The impact of banking and fiscal policies on state-level economic growth.

• Author: Abrams, Burton A.

1. Introduction

   Understanding the institutional arrangements that affect economic growth is an important subject that has received substantial attention in recent years.(1) Although most research has focused on the sources of growth across countries, a number of recent studies have sought to explain variation in economic growth between U.S. states. Barro and Sala-i-Martin (1992; hereafter B&S) estimated a model with cross-section data that related income growth to initial income and the sectoral composition of income in each state. They found support for the hypothesis that real income per capita between states converged. Razzolini and Shughart (1997; hereafter R&S), using a considerably different model pooling cross-section and time series data, focused on the effects of state-level fiscal policies. They find that government size and to a lesser extent deficit financing produce negative and significant effects on economic growth.(2) Jayaratne and Strahan (1996; hereafter J&S) also pooled cross-section and time series data to test for the growth effects of institutional arrangements concerning banking. J&S found evidence that the removal of restrictions on branch banking positively and significantly increased state-level economic growth during the time period covered by their analysis.(3)

   We reexamine the abovementioned hypotheses, using a neoclassical growth model patterned after that used by B&S. We use this model to test the sensitivity of the previous findings of R&S, B&S, and J&S to changes in model specification and to shed additional light on institutional factors that may affect growth. Section 2 discusses the basic model and the hypotheses relating banking structure and fiscal policies to growth. Section 3 reviews the B&S model and explains the specific variables used to test hypotheses. Section 4 contains the findings and concluding remarks.

2. The Neoclassical Growth Model: Banking Structure, Fiscal Policies and Growth

   Following Barro (1997, p. 8), we define economic growth as the annual percent change in real income per capita, dy/y. Economic growth is a function of starting income per capita, [y.sub.0], and the economy's steady-state income per capita (target income), [y.sup.*]. The variable [y.sup.*] depends ". . . on an array of choice and environmental variables" (Barro 1997, p. 8). Empirically, the economy's economic growth depends on the difference between [y.sub.0] and [y.sup.*].(4) For any given [y.sub.0], factors that raise (lower) [y.sup.*] would raise (lower) growth. For any given target [y.sup.*], an increase (decrease) in [y.sub.0] would lower (raise) growth. Aside from [y.sub.0], variables that enter the model are expected to affect the target [y.sup.*].(5) We now discuss the banking and fiscal policies that might affect the target [y.sup.*].

   Banking Structure

   In the movie classic, It's a Wonderful Life, George Bailey (played by James Stewart) is returned to his hometown (whose name has been changed from Bedford Falls to Pottersville) to observe the course of events had he and his family-run building and loan association not existed. Without George and the Bailey Brothers' Building and Loan, only a monopolistic commercial bank is left and the town's development takes a decided turn for the worse. Even the most casual moviegoer is drawn to the conclusion that financial institutions matter. In homage to the movie's director, the suggested linkage between banking structure and economic development might be dubbed the "Capra hypothesis."(6)

   The importance of indirect finance and financial intermediaries for economic growth and development has received considerable attention (see, e.g., Schumpeter 1911; Goldmsith 1969). Indirect finance, when compared to direct finance, is expected to increase savings and investment and improve the allocation of capital (the !ink between indirect finance and economic development is hereby dubbed the "Schumpeter hypothesis"). The Capra hypothesis goes beyond the categorical claim of the importance of financial intermediaries to suggest that the structure of the financial intermediation sector has important aggregative and allocative effects.(7) In support of the Capra hypothesis, Gerschenkron (1962) argued that changes in banking structure played instrumental roles in stimulating industrial economic growth in France and Germany in the late nineteenth century.(8) In a recent empirical study, King and Levine (1993) found evidence in support of both the Schumpeter and Capra hypotheses by empirically linking various measures of financial sector development, including the types of financial institutions conducting intermediation, to cross-country economic growth.(9) Most recently, J&S (1996) found that removing restrictions on branch banking improved bank lending quality, leading to higher growth rates. These studies suggest that banking structure is an important determinant of target [y.sup.*]. Differences in financial structure across U.S. states suggest various testable hypotheses.

   Unit Banking

   As noted above, J&S found evidence that branch bank deregulation raised the target [y.sup.*]. At the start of the century, virtually all states maintained unit banking laws, which restricted banks from opening subsidiary offices called branches. By the end of the Great Depression, a majority of states had abandoned unit banking laws and allowed some form of branching. However, approximately one-third of the states remained committed to unit banking until well into the century. The 1980s and 1990s found another wave of states shifting away from unit banking laws.(10) In 1994, federal passage of the Riegle-Neal Interstate Banking and Branching Efficiency Act set the stage for nationwide branch banking, but by this time all strict unit banking laws had been eliminated at the state level.

   Unit banking laws have been criticized extensively for their inefficiency and anticompetitive effects.(11) Proponents of branch banking claim it would ". . . improve the integration of the financial system and the mobility of funds" (Kohn 1991, p. 199).(12) The research of J&S supports the view that loan quality is improved also. Thus, a state that imposes unit banking laws may affect adversely the target [y.sup.*].(13) In our empirical analysis, we test for the effects of unit banking laws and other branching restrictions on the target [y.sup.*].

   Financial Depth

   King and Levine (1993) found evidence that financial depth is an important determinant of economic growth. One measure for differences in financial depth across states is total assets held by depository institutions relative to state personal income. Including a variable that controls for deposit institution depth across states provides a test of the Schumpeter hypothesis.

   Institutional Mix

   Resource allocation and the target [y.sup.*] might also be affected by the mix of financial institutions within the state. Goldsmith (1969, p. 395) notes that ". . . financial institutions may finance other types of capital expenditures, differing in form, durability, industry, location, or any other characteristic from the distribution that would have obtained if primary securities had been the only way of financing capital expenditures in excess of own savings and the only outlet for saving in excess of own investments." The same line of reasoning can be applied to differing distributional effects arising from different types of financial institutions. Some types of financial institutions may have better information and conduct better risk management than other financial institutions. In the U.S., commercial banks and thrift institutions (primarily savings and loan associations [S&Ls]) control well over half the total assets of all financial intermediaries. Historically, the balance sheets of S&Ls and commercial banks have differed substantially.(14) These differences in balance sheets are due in large part to regulatory restrictions and prohibitions relating to balance sheet management for each kind of depository intermediary.(15) The mix of these...