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Incidentally, all three models considered here agree on a common formula to determine the level of accumulation of capital stock but disagree on what they consider to be the level of investment in the economy; the Smithian model considers a direct relationship between the level of investment and the level of profits while the neoclassical model relates the level of investment to the level of Gross National Product (GNP). The Rostovian model assumes that the level of investments is directly related not only to the level of profits (as in the Smithian model) but also to the rate of growth of profits.

While the Smithian model considers the value of land to be fairly fixed, the neoclassical model assumes land to grow at a rate equivalent to the growth rate of GNP. Rostow however is of the view that the value of land encounters varying levels of growth swings.

Rostow (1990) identifies three levels of technological advancement. The first level is associated with growth in returns to scale as a result of increased specialization leading to an increase in the overall size of the market for goods and services. The second level of technological advancement is associated with pockets of discoveries such as scientific discoveries leading to improvements in the way processes are executed; this sort of development occurs randomly. The third form of technological advancement is the slow form of knowledge accumulated gradually over the years and through generations; this form of advancement due to the slow accumulation process is not considered to have a noticeable short run effect on the society. The Smithian model does not consider technological breakthrough as being a regular occurrence, it rather employs a pessimistic approach to technological advancement considering it to occur randomly and therefore not being a constant factor of significant change in the economy (Rostow 1990).

2.2.2 The Neoclassical Growth Model The neoclassical model was proposed by Solow (1956) as an improvement on existing models of economic growth. The model which sought to infuse a new ideology in the theoretical understanding of economic growth embraces technological progress as a regular occurrence in the economy. The magnitude of technological advancement in this model is very large compared to the views of Adam Smith. The model assumes that technological changes occur in isolation of changes in other macroeconomic variables. Rostow (1990) argues that the long run effect of technological advancement in the neoclassical model and the Smithian model are near equal measures considering that a steady growth in technology of say 2% per annum in a particular country using the neoclassical model over a ten year period is equivalent to a sudden advancement of 20% in a particular year for another country according to the Smithian model. Both countries will be at the same level of technological expertise.

In summary, the neoclassical model assumes that the value of savings is in direct proportion to the GNP and that when there is a variance in their values, that variance is defined as consumption; technological advancement is a continuous occurrence having an immediate impact on society; labour and therefore real wages grow at a constant annual rate; land and other natural resources grow at a rate that causes the real level of rent to remain constant (Solow 1956, Rostow 1990).

2.2.3 The Rostow Growth Model Rostow (1956) argued that a better way of looking at economic growth is to view economic growth as occurring within a short period of time (two to three decades) for a particular country; he identified this period as the “take-off”.

This model considers technological advancement from two points of view; the first being all backlogs of advancements a country should have adopted which is referred to as an autonomous factor and the second factor referred to as an endogenous factor looks at how enthusiastic the country is in advancing its technological framework in the future (research and development) (Rostow 1990). The autonomous factor immediately distinguishes developed from developing countries as there is little doubt that Nigeria will have more technological backlogs than the United States of America. Efforts at research and development however is future bound but can be measured in terms of human and capital investment set aside for such research in the present time.

The Rostovian growth model assumes that land and other natural resources will grow according to the amount of resources devoted to them both endogenously and exogenously. In this regard, the Rostovian view is at variance with the neoclassical view which assumes such increases are wholly exogenous. The Rostovian model also assumes that labour force will grow at the rate of growth of economic development while the neoclassical model assumes constant growth all through.

A major critique of the Rostovian growth model is that the underlying engine of change governing the different stages of growth was not specified and as such remains a classification of stages with no driving linkage (Baran and Hobsbawm 1961).

A key issue this literature review has highlighted is how each of these models impacts on development in the developing as well as growth in the developed world to determine if there exists a transition period in the growth of an economy from developing to developed where each model plays a role or becomes obsolete. Rostow (1990:564) however purports that the modern growth models are hybrids of the Smithian model whereby a restraint has been placed on the growth of the labour force, technological advancement is regular and increase in land and natural resources is regular.

2.2.4 The Schumpeterian Model Schumpeter (1911) applied a slightly different relationship to modelling the finance-growth nexus. He worked up his argument from the stand point of innovative ideas in production in the basic circular flow model of the economy whereby households earn an income as a result of their productive activities and proceed to spend part of this income on products of enterprise while a proportion of their income is saved. In his view, this circular flow system represents a static economy and if the economy where to grow, innovative ideas relating to better methods of industrialization would have to be funded.

The volume of funds required would be far in excess of society’s savings requiring recourse to the banking system (the Central Bank) to create more money and disburse through commercial banks that create credit to entrepreneurs. In other words financial development (through the banking system) assists society to originate new technologies leading to growth in the economy. In his view, the banker is the provider of capital that facilitates technological change. As much as this view has been overtaken by more recent and direct views of how financial development connects with economic growth, the Schumpeterian model still indirectly connects these two concepts of financial development and economic growth (Schumpeter 1911, Clemence 1951:228 and King and Levine 1993:735). Schumpeter argued that five variables were relevant to the incidence of financial development, economic growth and economic development. Capital and population growth he argued leads to economic growth and change in consumer preference he argued is an intrinsic part of the circular flow process. The last two variables, organization of productive capacity and innovation in productive technique he argued are salient to economic development as they are the key components of entrepreneurship.

A very salient point arising from Schumpeter’s analysis of the relationship between financial development and economic growth is that innovations in production processes will have to be made manifest before the need to seek financial outlets to fund the innovations which will then lead to economic development as a result of the funding. In contemporary society, this strand of argument can be rolled back a step or two to argue that finance generated via financial development can be used to fund research which will generate innovations. This new argument even though different from Schumpeter’s original point of view finds its root within the Schumpeterian School. In a study of early US economy growth patterns, Rousseau and Sylla (2005) provide compelling empirical evidence to support the Schumpeterian growth model by showing that the financial system by providing funding supported a series of technological advancements which ultimately improved the way people do business leading to economic growth.


2.3.1 Bank Based Finance-Growth Models The theory proposes a model whereby financial development is based on the development of a strong banking system capable of gathering information about potential investors, exerting corporate control over managers and their activities, granting loans for corporate expansion, consumer use and industrial development (Levine 2004). This theory finds its roots in the works of Schumpeter (1911) further consolidated by Goldsmith (1969). A bank is an institution licensed by law to collect deposits, issue credit in the form of loans and overdrafts, carry out financial advisory services as well as a host of other non financial services like document safe-guarding etc (Koch and Macdonald 2000). Traditionally banks use the credit scoring system to evaluate the credit worthiness of potential loan customers as a guide to the maintenance of a healthy risk asset portfolio (Koch and Macdonald 2000). This system is based on a database of information with easy accessibility by potential lenders.

However widely used this practice is in the Western banking system, caution has to be applied in assuming that similar practices occur the world over. In the Nigerian banking system where information flow is hindered by technological advancements and irregular power supplies, banks adopt a different mechanism for monitoring their loan customers. Evaluation for qualification of a loan is based largely on the duration of relationship with the bank as well as a cash flow analysis of the customer’s bank account. The implication of this is that goodwill cannot be transferred across the sector (in the case of a business or individual deciding to change his banker, he will be required to build a new relationship with the new banker in order to qualify for credit to fund his growth initiatives) resulting in a major hindrance to investment and thereby stifling innovation. Knowledge of this practice is based on my personal experience working in the Nigerian Banking Industry.

Boot and Thakor (1997) and Demirguc-Kunt and Maksimovic (2002) examine the economic significance of a bank against the financial market and deduce that economies in their budding stage often place more reliance on banks for the provision of investable funds. The implication of their view is that banks apply all forms of caution to maintain a healthy relationship between their liabilities and their assets which in most cases are funded up to ninety percent by liabilities. They proposed a theory that identifies more sophisticated borrowers as seeking funds from the bond and equity markets while less sophisticated borrowers seek bank loans. They conclude by saying that as a system increases in its level of advancement, emphasis of borrowers tend to shift from bank sourced funds to capital market sourced funds. This view was

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acknowledgement that banks tend to increase their operational capacity as the economies in which they function increased in magnitude but capital markets tended to outgrow banks with this growth in the economy.

Goldsmith’s view was also given empirical evidence by Demirguc-Kunt and Maksimovic (2002). Evidence of Goldsmiths bank-growth theory may have been made manifest in the Nigerian Banking Industry consolidation scheme led by the Central Bank of Nigeria (CBN) in 2006 where the Governor of the Central Bank increased the minimum equity capital of commercial banks by 1000%, a move he asserted was targeted at increasing the competitiveness of Nigerian Banks beyond the national boundaries. In the wake of this new requirement, a wave of mergers and acquisitions saw a consolidation of 81 commercial banks down to 25 full service universal banks (For further details see the website of the Central Bank of Nigeria). An error with the Boot and Thakor analysis however is that they assumed that in a bank based system, factors making up the system can cooperate while in a market based system factors making up the system are in competition. This assumption gives the impression of a single bank operating under the same management but with a nationwide branch network. This may normally not be the case as banks today are as varied in management as they are varied in market strategy (Koch and Macdonald 2000). Even though their argument is in favour of a market based system, the flaw in this assumption limits the applicability of this analysis.

2.3.2 Market Based Finance-Growth Models The financial market is the market for corporate bonds, equity and in recent times, more sophisticated instruments like derivatives. These markets are highly dispersed, functioning primarily through agents and brokers. Because of the size and magnitude of today’s financial markets (Hull 2003), banks have joined the race in acting as agents and brokers to their customers and non-customers alike in moving their savings into security portfolios in the financial markets as evidenced in the United Kingdom where banks offer access to and manage portfolios of investments hitherto not traditionally associated with banks. This constitutes a contradiction of the stratification between the bank and market based models.

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