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CHAPTER ONE INTRODUCTION 1.0 Background of Study Over the past half century, developmental economics has undergone many changes as emphasis has shifted from the growth in gross domestic product (GDP) per capita (Morawetz, 1977), to employment creation (Lewis 1954; Kuzent, 1955), to basic human needs (see, Goldstein, 1985), to stabilization and structural adjustment (see, Jhingan, 1984), to human capabilities and development (Sen, 1989), and recently, to sustainable development (World Development Report, 1999-2000). These changes in developmental economic policies over time from growth in GDP per capita to sustainable development could be attributed to the desire of nations to address the problem of poverty which is predominant in less developed economies of the world (Sub Saharan African countries inclusive). The Brundtland report of the World Commission on Environment and Development in 1987 however brought to limelight the concept of sustainable development as the report defined it as ?meeting the needs of the present generation without compromising the need of the future generation? (Jhingan 2012:12). Thus, economic development must be sustainable implying that it should be on-going and dynamic in order to achieve the goal of poverty eradication. The World Development Report (1999-2000) emphasizes the creation of sustainable improvement in the quality of life for all persons as the principal goal of development policy. According to the report, sustainable development has many objectives; beside increasing economic growth, meeting basic needs, and lifting the standard of living of citizens, it also include a number of specific goals such as; bettering people?s health and educational opportunities, giving everyone the chance to participate in public life, helping to ensure a clean environment, promoting intergenerational equality and much more (World Commission, 1999-2000). Thus, meeting the need of the people in the present generation is essential in order to sustain the needs of future generations and the ability of developing economies to achieve these objectives hinges on her ability to enhance rate of savings, profit rate, rate of capital accumulation, technical improvement, equitable distribution of wealth, expansion of foreign trade and institutional changes, etc (Jhingan, 2012). Among all the factors of economic development, the rate of savings and capital accumulation has been described as one of the most important and necessary conditions to the achievement of economic development of nations. No wonder from Smith (1776) to Kings and Levine (1993), it has been argued that finance plays an important role in the enhancement of economic development through its financial intermediation (savings and capital accumulation) function. From the classical economic perspective, Smith (1976) regards every person within the society as the best judge of his/her self interest who should and must be left alone to pursue it to his/her own advantage. In furthering their personal interest, the interest of the society is enhanced through the invisible hand mechanism. Smith (1776) regards financial intermediation (capital accumulation) as a necessary condition for economic development and opines that the process of economic development was largely as a result of the ability of the people to save more and invest more in their country, thus, Smith (1776) summaries that in any society every prodigal appears to be a public enemy and every frugal man a public benefactor (Jhingan, 2012:87). In line with the above statement, therefore, the level of capital accumulation through savings is principally a necessary condition for economic development of nations. Malthus (1836) also made mention of the role of financial intermediation on economic development. However, he was concerned with the progress of wealth which means economic development that could be achieved by increasing, the wealth of a country. According to Malthus (1836), of all the factors of production which are necessary condition for economic development, it is the accumulation of capital that is the most important determinant of economic development. It was against this background that he suggests the concept of the optimum propensity to save. This means saving from the stock which might have been destined for immediate consumption thereby adding to that which is to yield profit or in other words in the conversion of revenue into capital (Malthus, 1836) Mills (1871) emphasizes the role of finance in the enhancement of economic development of nations. According to Mills (1871) economic development is a function of land, labour and capital and while land and labour are the two original factors of production, capital is a stock previously accumulated of the products of former labour. According to Mills (1871), the rate of capital accumulation depends upon the amount of the fund which savings can be made or the size of the net produce of industry and the strength of the disposition to save. Therefore, capital is the result of savings and savings comes from the abstinence from present consumption for the sake of future goods. Thus for nations to achieve sustainable development, there must be an effective desire to accumulate capital (Mill, 1871). Like Smith (1776), Ricardo (1917) highlights the connection between financial intermediation and economic development however, he pointed towards the importance of capital accumulation through agricultural development and increase in the various sources of saving and profit rate. According to Ricardo (1917) capital accumulation which is a process of financial intermediation is the outcome of profits as profits lead to saving of wealth which is used for capital formulation and this is dependent on the capacity to save and the will to save. Thus, for any economy to develop, such economy must enhance her capacity to save. Karl Marx, according to Jhingan (2012), discusses the connection between financial intermediation and economic development. Marx refers to financial intermediation which he called the surplus value as a process of economic development. According to Marx, every society?s class structure consists of the ?have? and ?have not? and states that since the mode of production is subject to change, a stage will come in the development process of nations when the forces of production will come into clash with the society?s class structure. This will eventually lead to class struggle which ultimately will overthrow the whole social system. Thus, Marx used his theory of surplus value as the economic basis of the class struggle under capitalism to building the super structure of his analysis of the process of economic development (see Jhingan, 2012). Schumpeter (1911) also discusses the importance of financial intermediation in the enhancement of economic development. According to Schumpeter (1911), economic development is a spontaneous and discontinuous change in the channel of the circular flow, disturbances of equilibrium which forever alters and displaces the equilibrium state previously existing. Schumpeter (1911), thus states that, economic development starts with the breaking-up of the circular flow (stationary state) with an innovation in the form of a new product by an entrepreneur for the purpose of earning profit. In order to break the circular flow, the innovating entrepreneurs are financed by bank-credit expansion (financial intermediation process). Therefore, since investment is assumed to be financed by the creation of bank credit, it increases income and prices and this help to create a cumulative expansion throughout the economy thereby inducing economic development (Schumpeter (1911). The Keynesians were also not left out at providing a link between financial intermediation and economic development. Though there link does not analyze the problems of underdeveloped economies it had relevance to advanced capitalist countries. According to Jhingan (2012), total income is a function of total employment in a country, thus, the greater the national income, the greater the volume of employment. Again, according to them the volume of employment depends on effective demand and effective demand determines the equilibrium level of employment and income. Therefore, for any economy, effective demand is determined at the point where demand price aggregate equals aggregate supply price. Effective demand according to the Keynesians consists of consumption demand and investment demand. While consumption demand depends on the propensity to consume, investment demand which is largely as a result of financial intermediation does not increase at the same level as the increase in income, hence, the gap between income and consumption is made up by investment which grows the economy (Jhingan, 2012). Rostow (1960) also provides his own thought on the effect of financial intermediation on economic development. He sought and advocated a historical approach to the process of economic development. He distinguished five stages of economic development viz a viz the traditional society, the pre-conditions for take-off, the take-off, the drive to maturity and the age of high maturity consumption. According to Rostow (1960) while the traditional society is based on one whose structure is developed within the limited production functions based on pre-Newtonian science and technology, the pre-condition take-off stage is based on the idea that economic progress is possible and is a necessary condition for some other purpose, judged to be good. Therefore, at this stage, new types of enterprising men come forward in the private economy, in government or both willing to mobilize savings (financial intermediation) and to take risks in pursuits of profits to modernization (economic development). Emphasizing the role of financial intermediation on economic development, Rostow (1960) summarized that: ?as banks and other institutions for mobilizing capital appears, investment increase, notably in transport, communication and in raw materials in which other nations may have an economic interest. The scope of commerce, internal and external widens and modern manufacturing enterprises appear using new methods? (Rostow, 1960:6-7) Gerschenkron (1962) also supports the importance of finance in the enhancement of economic development. According to Gerschenkron (1962), all nations were backward once, thus, to move from the traditional levels of economic backwardness to a modern industrial economy required a sharp break with the past. Gerschenkron (1962) categorized countries into three groups on the basis of their degree of economic backwardness: advanced, moderately backward and very backward. To put perspectives on the role of financial intermediation on the development of these economics Gerschenkron (1962) notes that advanced nations started their first stage of development with the factory as the organization lead; moderately backward nations starts with banks and extreme backward nations with government. However, as argued by Gerschenkron (1962), as a necessary precondition for development, financial institutions through the process of intermediation can play an important role in the achievement of economic development through the enhancement of capital accumulation. Given the contributions of economists such as Smith, Ricardo, Malthus, Keynes, Rostow and Gerschenkron from 1776 to 1962, recent literature have also emphasized on the role of financial intermediation on economic development. Though these recent literature have emphasized more on economic growth rather than economic development. These recent literature have supported their argument with empirical results to buttress the impact of finance on economic growth. Leading recent literature in this regard is king and Levine (1993) who citing Schumpeter (1911) opine that the services provided by financial intermediaries (mobilizing savings, evaluating and facilitating transactions) are essential for technological innovation and economic development. It was against the importance of financial intermediaries in performing the above functions that king and Levine (1993) conducted a pooled cross country time series survey of eighty countries for the period 1960-1989 with the view to establishing the relationship between financial intermediation and economic growth. Their findings suggest that financial intermediation has a significant impact on growth. Taking a cue from king and Levine (1993), Jayaratne and Strathan (1996) support the influence of financial intermediation on economic development though their emphasis were on development through growth, however, with a clause that there should be an improvement in the quality of bank lending and not necessarily the volume of bank lending. Contributing to these debates on finance and growth, Ragan and Zingales (1998) assert that financial development enhances growth in indirect ways through the contribution of external financing. Demirgue-Kunt and Maksimovic (1998) in supporting the role of finance on economic development were of the view that an active stock market is an indication of a well developed financial system and they assert that firms in a country with a high rate of compliance with rules and regulations have access to the capital market. Thus, a developed financial system will ensure growth of firms listed in the exchange thereby stimulating development. Amongst other recent works which have increased literature on finance and growth are Odedokun (1998), Levine, loayza and Beck (2000), McGaig and Stengos (2005), Hao (2006), Deidda (2006), Romeo-Avila (2007), Odhiambo (2008) and Shittu (2012) etc. As stated earlier, a review of recent literature indicate that previous works in this area of economics and finance have focused on the impact of finance on economic growth which often are based on figures from developed economies. The adoption of recommendations from these works obviously may not have any significant effect on the economies of less developed countries (especially Sub Saharan African countries) because policy implication from economic growth oriented literature is quite distinct from economic development oriented literature because growth and development are two distinct words. Again, what developing economies need is economic development polices which encompasses growth if the high rate of poverty which is prevalent is to be conquered. Thus, as stated by Maddison (1970), economic development refers to the problems of underdeveloped countries and economic growth to those of developed countries. He summarized that . ?the rising of income level is generally called economic growth in rich countries and in poor ones it is called economic development. (Maddison, 1970:5). However, this view does not specify the underlying forces which raise the income level in the two types of economies. Hicks (1957) points out in this connection that the problem of underdeveloped countries are concerned with the development of unused resources even though there are well know, while these of advanced countries are related to growth as most of their resources is already know and developed to a considerable extent.