The Balance of the Tripod: Literacy–Stability Divergence and Economic Growth in Developed and Developing Economies

Abstract

Traditional composite indexes of financial development usually include only the first principal component of the pillars, implying that there is only a single latent dimension of financial development which accounts for all the variation relevant to growth. In this study, what happens when we assume otherwise? A two-stage PCA, computed on a balanced economy panel, using the same eight economies (four OECD: Australia, Canada, Finland, Germany and four SAARC: Pakistan, India, Bangladesh, Sri Lanka), over the period 2004–2022, reveals that the key dimensions of the financial tripod – inclusion, literacy, and stability – are empirically two-dimensional, with a second PCA axis orthogonal to the balanced-development composite and loading positively on financial literacy and negatively on bank stability explaining 41.2 percent of the variance in the pillars, and the combined share of these two axes being 87.1 percent. We view this second dimension as a literacy–stability divergence, that is, the degree to which the demand-side knowledge pillar grows faster than the institutional stability pillar, and examine its growth implications in a two-way fixed-effects framework estimated in first differences with standard errors of the Driscoll–Kraay type, a framework that directly tackles the non-stationarity, serial correlation and cross-sectional dependence problems typical of small-N macro-financial panels. The coefficient of Divergence growth in the developing sub-sample is strongly and robustly negative in all re-estimations with one country removed from the sample (β = −6.07, p < 0.001), but is exactly zero in the developed sub-sample. This is substantiated by a development-status interaction (p < 0.001). The results suggest that, in the context of developing economies, the financial tri-pod's growth premium is not just the advance of the pillars, but a measure of whether they move together or not and a sort of growth penalty for the output cost of literacy-led expansion without the commensurate institutional stability.

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