These observations point to the question of why more countries do not respond to financial instability by suppressing financial markets and transactions. The answer is that policies that stifle financial development have economic costs. Financial development relaxes borrowing constraints, thereby enabling new firm formation, intensifying competition, and facilitating the adoption of new technologies. There is overwhelming evidence of the positive association of financial development with productivity growth (Guiso, Sapienza and Zingales 2002). Well-developed financial markets disseminate information about profitable and productive investment opportunities, enhancing the efficiency with which capital is allocated. They help with monitoring managers and strengthening corporate control, positively influencing the efficiency with which resources are allocated within the firm. They mobilize savings, facilitate specialization, and encourage exchange. How important are these effects? Financial development that raises financial depth, as measured by the ratio of domestic credit to GDP, from 0.25 to 0.55 – that is, from the levels typical of financially underdeveloped countries to that typical their more financially well developed counterparts – raises the rate of economic growth by a full percentage point per annum according to the widely-cited estimates of King and Levine (1993). These numbers are large. By the iron law of compound interest, raising growth by a percentage point a year raises incomes by a third in a generation.7 This suggests that the benefits of financial development are at least as large as the costs of financial instability. Thus, the costs of a policy that limits financial instability by limiting financial development may be even greater than its benefits. Additional calculations consistent
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