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What Is the Connection between Financial Markets and Economic Growth?

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  • Written By: John Lister
  • Edited By: O. Wallace
  • Last Modified Date: 30 May 2018
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The connection between financial markets and economic growth is a controversial subject; one theory is that financial markets make it easier for companies to access capital to grow their business and boost output. Taxation from financial markets may also increase government revenue and in turn boost growth. The financial crisis that begin in 2007 has suggested, however, that there may be limits on the relationship between financial markets and economic growth.

Most theories about financial markets and economic growth are based on the type of assets that financial markets deal with. Traditionally most of these assets have either been equity products such as stocks, or debt products such as bonds. In all of these cases, although investors trade assets with one another in the hope of making a profit or receiving income, ultimately the asset begins with investors, via the market, providing money to businesses or governments. This money commonly funds capital spending such as investment in machinery or other production assets. In most cases, capital spending is seen as a boost for growth as it increases the potential output of companies, which is often realized.

Increasingly globalized financial markets can boost this process. Without financial markets, companies would need to get funding from banks, which usually restricts the company to domestic funding. Financial markets make it easier for companies to access investment and funding from overseas sources, thus increasing the availability and potentially decreasing the cost of such funding.

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In some countries, taxation of companies involved in financial markets, or taxation of market transactions, can play a key role in government revenue raising. This can boost growth by allowing governments to spend more on infrastructure, which helps businesses perform more efficiently. Raising money this way may also reduce the need for taxes that could limit growth, such as personal income taxes that reduce disposable income among consumers.

There are arguments that the success of financial markets and economic growth are not so closely linked. This is mainly because of the growth of trading in derivatives, which are assets that don't have an intrinsic value but are instead based upon other assets. Depending on the type of derivative involved, little if any money from such markets will find its way to the businesses or governments that issued the original asset. It can be argued that derivative trading is a "zero sum" game meaning that the investors simply pass gains and losses back and forth, with no overall benefit to the economy.

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