The Evolution of the Finance-Growth Nexus

Paul WachtelStern School of Business, New York University

Restoring Inclusive Growth in Advanced EconomiesOctober 8, 2010

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Overview

Modern growth theory and development economics ignored finance

Change in 1990sFinance CAUSES growth

Entered the canon of economists beliefsBut, what do we really know?

When / how is expansion of financial sector beneficial?

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Growth empirics

Solow introduced framework – 1956 TFP or Factor accumulation

Understanding East Asia miracle Mystics vs. Fundamentalists

Understanding TFP Technological progress and knowledge transfers Experience of Soviet economies

Resource allocation also important

Finance as a source of allocative efficiency

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Finance-growth empirical nexus

OriginsGoldsmith (1969), McKinnon (1973)

Empirical groundbreakersBarro, King, Levine, et al – cross country

studiesWachtel, Rousseau – time series studies

Measuring financial developmentSize – depth - of financial sectorRatio of intermediation / GDP

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Average Growth Rate

Financial depth quartile

M3/GDP Credit/GDP

1 Highest 2.81 2.84

2 2.20 2.41

3 1.65 1.21

4Lowest 0.68 0.94

84 countries1960-2004

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Problems with panel evidence

GDP growth

Financial depth

Little within countryrelationship but, large between country differences.

Long time series evidence

Panel data evidence

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Can we believe the econometrics?

Broad money to GDP ratio – Distribution of countries:

⅓ -- < 40%; ⅓ -- 40-60%, ⅓ -- > 60% 10 percentage point increase in depth 1 percentage point increase in growth rate

TOO GOOD TO BE TRUE

Makes growth look too easy!

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Case based approach

Ongoing work with Peter Rousseau

---- Episodes of financial deepening and subsequent growth experience

What is an episode?Deepening over a 5 year period above a

threshold1960-2007 – 144 countries.

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Preliminary evidence

Cut to the chase

Q - Are episodes of financial deepening followed or accompanied by a sustained growth spurt?

A - NO.

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Debt/GDP ratio in the US

Ratio increased by about one-third in the 80s and again in the 00s.

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US deepening episodes

Two deepening episodes periods of increased financial activity and

innovation in the financial sectorDid they enhance resource allocation and

lead to economic growth?Or, are these simply periods of

increased leverage and risk taking that were associated with financial crises (market crash in 1987 and crisis of 2007-08).

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Focus on financial crisis

Identify crises and look at commonalities in pre and post crisis experience.

Reinhart and Reinhart (Jackson Hole 2010) - 15 severe crisis since 1975Median 10 year pre-crisis increase in bank

credit / GDP --- 38.4 percentage points.Substantial financial deepening before

every crisis!

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Research problem

How do we distinguish betweenFinancial deepening and growth of financial

sector that improves allocative efficiency and generates economic growth

ANDCredit booms that increase leverage and

risk taking which often (not always) leads to financial crisis and recession.

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Perhaps, with different data

Deepening tells us about leverage, amount of intermediation.

May not relate closely to the quality of intermediary activity

Theoretical work (Philippon, Jovanovic and Rousseau) relate eras of economic innovation and technological progress to the growth of intermediary activity. New, innovative firms require financial innovations.

Alternative measure -- Value added in the financial sector

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Financing growth or crisis?

Industrialization

Modernization

Digitalization

Credit Booms

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Financial intermediation % of output

United States √ 6.4 (87) 8.2

Australia √ 7.2 (89) 10.0

Austria 6.0 5.3

Canada 5.2 6.0

Denmark 4.8 5.4

Finland 3.1 2.5

Italy 5.1 4.8

Korea √ 3.9 6.9

Mexico 3.1 (88) 3.7

Netherlands √ 5.8 7.7

New Zealand 6.4 (86) 6.3 (04)

Norway 3.7 4.0

1985 2005

2005Ireland 9.7Iceland 10.2

√ = 25% or more

increase

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Problem still stands

Researchers (championed by Levine) that established the finance-growth nexus

Were just not the same people as those looking at crises Earlier crises were (e.g. Japan, Scandinavia) were

accompanied by increases in leverage It was just assumed that bubbles were a different

phenomenon

How little we know!

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Policy implications

What can the research community tell the policy community?

Clear benefits of financial sector to less developed countries – development of market, credit based economy.

Implications of deepening or growing financial sector less clear for highly developed economies Will increased regulatory constraints inhibit the next

wave of technological innovation? Will increases in financial depth generate larger and

more frequent crises?

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Financial policy for 21st century

Policy needs to have a broader understanding of the role of the central bank.

Crisis has fundamentally changed our view of the role of a Central bank

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Central bank history

19th century Lender of last resort Regulate individual banking institutions because of

a concern for systemic risks (called panics) Early 20th century

The systemic aspect of central bank responsibility disappeared in the US (Fed’s failures in the Depression)

Central bank lending focussed on (individual) banking institutions

Mid 20th century Macroeconomic role of central bank emerged

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Central bank history

Late 20th centuryMacro policy role of central perfected

Inflation targeting and interest rate policy conducted by an independent central bank

Bank regulatory role de-emphasized to the point of disappearance

And issues of systemic risk (except for concern about the payments system) never enters discussions of central bank role.

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Central bank history

One wonders why central bank research community never addresses the research question that I posed.

Late 20th century view very narrow focus of bank interestsAsset price inflation and bubbles given little

attention; viewed as an unnecessary diversion from inflation targeting

Regulatory activities ignored.

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Implications of crisis

Central banks have three interests

Macroeconomic monetary policy

Regulation of financial institutions

Systemic risks to the financial system

Further,

These three are interrelated and overlapping.

E.g. the macro growth and crisis implications of financial deepening.