Although research shows that financial development accelerates aggregate economic growth (Levine, 2006), economists have devoted few resources to resolving conflicting theoretical predictions about the distributional effects of financial development. Some theories imply that financial development disproportionately helps small firms. If smaller firms find it more difficult to access financial services due to greater information and transaction costs, then financial development that ameliorates these frictions will exert an especially positive impact on smaller firms (Galor and Zeira, 1993; Aghion and Bolton, 1997)). In contrast, if fixed costs prevent small firms from accessing financial services, then financial development will disproportionately help larger firms (Greenwood and Jovanovic, 1990; Haber et al., 2003).
Besides assessing theoretical disputes, political economy and public policy considerations motivate our study of the cross-firm distributional effects of financial development. If financial development affects small firms differently from large ones, then firms might disagree about the desirability of financial reforms. Even if financial development helps all firms, one set of firms might oppose financial reforms that diminish the group’s comparative power, which is consistent with influential work on the political economy of financial policies such as Kroszner and Stratmann (1998), Kroszner and Strahan (1999), Rajan and Zingales (2003), Pagano and Volpin (2005), and Perotti and von Thadden (2006). Rather than analyzing political lobbying by firms of different sizes, we examine whether financial development has cross-firm distributional effects. In addition, the World Bank pours about $2 billion per year toward subsidizing small firms, which further motivates our examination of the cross-firm distributional effects of financial development.
We examine whether industries that have a larger share of small firms for technological reasons grow faster in economies with well-developed financial systems. As formulated by Coase (1937), firms should internalize some activities, but size enhances complexity and coordination costs. Thus, an industry’s “technological” firm size depends on that industry’s particular production processes, including capital intensities and scale economies. After computing an estimate of each industry’s technological share of small firms, we use a sample of 44 countries and 36 industries in the manufacturing sector to examine the growth rates of different industries across countries with different levels of financial development. If “small firm industries” industries naturally composed of small firms for technological reasons grow faster than “large firm industries” in economies with more developed financial systems, this suggests that financial development boosts the growth of small firm industries more than large firm industries. In contrast, we might find that financial development disproportionately boosts the growth of large firm industries or that financial development fosters balanced growth.
More specifically, we use a difference-in-difference approach to examine whether financial development enhances economic growth by easing constraints on industries that are technologically more dependent on small firms. We first measure an industry’s “technological” composition of small firms relative to large firms as the share of employment in firms with less than 20 employees in the United States in 1992. Assuming that financial markets are relatively frictionless in the United States, we therefore identify each industry’s “technological” share of small firms in a relatively frictionless financial system. Then, we extensively test the validity of this benchmark measure of technological small firm share by using (i) using data from the U.S. in 1958 to compute small firm share, (ii) measuring small firm share at different stages of the U.S. business cycle, (iii) computing technological small firm share from different countries, and (iv) defining small firm in different ways, ranging from five to 500 employees.
The results indicate that small-firm industries grow disproportionately faster in economies with well-developed financial systems. This does not imply that financial development slows the growth of large firms. Rather, financial development exerts a particularly positive growth effect on small-firm industries. Furthermore, our analyses suggest that large-firm industries are not the same as industries that rely heavily on external finance. Rajan and Zingales (1998) show that industries that are technologically more dependent on external finance grow disproportionately faster in economies with better developed financial systems. When controlling for cross-industry differences in external dependence, we continue to find that financial development disproportionately accelerates the growth of industries that are composed of small firms for technological reasons.
Download
Finance, Firm Size, and Growth
