Economists have long suspected that one reason why developing countries struggle to emerge from poverty is that they lack robust financial sectors, especially when compared to wealthier nations.

Although it may seem obvious that a weak financial sector would stifle growth within a developing country, until now few economists have tried to determine just how this phenomenon occurs. This has made it difficult for policymakers and investors to understand how financial markets may be failing and to create effective solutions to correct them.

EconomistsFrancisco J. Bueraof theUniversity of California-Los Angelesand the Federal Reserve Bank ofMinneapolis,Joseph Kaboskiof theUniversity of Notre Dame, andYongseok ShinofWashington UniversityinSt. Louis, present important insights to this phenomenon in a paper that is currently published in the journal "American Economic Review."

The authors used a computer-based economic model and data from 79 countries to quantify key aspects of the relationship between development and the financial sector. Their work suggests that poor financing environments in developing countries inhibit talented individuals from gaining the most from their abilities and result in lop-sided economic landscapes with few large firms and too many small ones. This ultimately slows economic growth.

The authors' framework examines two features of developing economies in particular: technologies that cause differences in the scale of production across sectors and the ability of entrepreneurs to overcome financial limitations by self-financing through savings.

The researchers show that the lack of financing affects productivity in both large-scale and small-scale industries, but it impacts large-scale industry disproportionately. In large-scale industries, such as manufacturing, poor financing opportunities make it harder to start businesses. This leads to too few entrepreneurs in the marketplace and even fewer large establishments.

Conversely, in smaller service industries, it is easier for entrepreneurs, such as retail shop owners, to self-finance,so the challenges to starting a business are actually reduced. This is also because the opportunity cost of choosing to start a business – earning a market wage and saving at the market interest rate – decreases. As a result, developing economies often end up with too many entrepreneurs and too many small establishments in the traditional service industries.

"We think these findings are significant because we can characterize by how muchpoor countries are being held back by the lack of financial development," concludes Buera. "The next step is to understand what might be done about it. Why aren't the credit markets more developed? How might enhancing credit markets increase returns on savings? What policies might we implement to solve this?"

The authors' findings also confirm that weak financial development — such as the lack of financial services — accounts for a substantial part of the difference between poor and rich nations' development; it accounts for poor countries' low per-capita income, their large differences across industrial sectors in prices and productivity, and their low aggregate total factor productivity (TFP), which is an indicator of how effectively an economy produces relative to the resources it uses.

"An important lesson from our analysis is that the lack of good credit markets also reduces the return to savers in an economy," notes Buera. "This makes it more costly for poor individuals to build up a buffer and protect themselves from the various risks they face. The use of economic models is important for uncovering these indirect, systemic effects of financial intermediation."