Finance and Growth: Too Much of a Good Thing?

By Thorsten Beck, Professor of Banking and Finance, Cass Business School; Professor of Economics, Tilburg University; Research Fellow, CEPR. Originally published at VoxEU.

A well-functioning financial system is critical for economic growth. However, some studies find a negative relationship between the two at high levels of financial development. This column discusses why this is the case and suggests some policy implications. It argues that reforms that refocus the financial system on enterprise credit and on internalising the downside risks can be beneficial. [Also too, jail time. –lambert]

Over the past 20 years, economists have accumulated a substantial body of empirical evidence that financial sector deepening is a critical part of the economic development process. This shows a well-functioning financial system is a conditio sine qua non for modern market economies to flourish. What started with simple cross-country regressions, as used by King and Levine (1993), has developed into a large literature using an array of different techniques to look beyond correlation and controlling for biases arising from endogeneity and omitted variables. These studies provided a consistent result – financial deepening is a critical part of the overall development process of a country (see Levine 2005, for an overview and Beck 2009, for a detailed discussion of the different techniques).

The findings of this literature, however, sit uncomfortably with the recent experience of many developed countries. It is not just the Global Crisis of 2007/8 that has shed doubts on the finance-growth paradigm, but there are more fundamental questions on the relationship between financial development and economic growth. Aghion et al. (2005) show that the relationship turns insignificant at higher levels of economic development, while Arcand, Berkes and Panizza (2012) show that the relationship even turns negative at very high levels of financial development.

Understanding the Link Between Finance and Growth

What are the reasons for this insignificant or even negative relationship between finance and growth across high-income countries? Recent papers have put forward several explanations. While these are not necessarily incompatible with each other, they have different policy implications.

  • First, the measures of financial depth and intermediation the literature has been using might be simply too crude to capture quality improvements at high levels of financial development.1

Some authors have argued that it is not so much the quantity of financial intermediation, but the quality that matters (Hasan, Koetter and Wedow 2009). The question is, however, whether there are limits to these efficiency gains, as there are to the volume of intermediation. In addition, the financial sector has gradually extended its scope beyond the traditional activity of intermediation towards so-called ‘non-intermediation’ financial activities (Demirgüc-Kunt and Huizinga 2010). As a result, the usual measures of intermediation services have become less and less congruent with the reality of modern financial systems. The literature has not developed yet good gauges of these non-intermediation services to properly assess their relationship with economic growth.

  • A second explanation focuses on the beneficiaries of the credit.

While the theoretical and most of the empirical finance and growth literature has focused on enterprise credit, financial systems in high-income countries provide a large share of their services, including credit, to households rather than enterprises. In several countries, including Canada, Denmark, and the Netherlands, household credit constitutes more than 80% of overall bank credit – mostly mortgage credit. Theory makes ambiguous predictions about the effects on the relationship between household credit and growth, and initial empirical evidence shows an insignificant relationship between the two (Beck et al. 2012). The relationship between financial deepening and economic growth goes through enterprise credit, and the fact that much of the financial deepening in high-income countries over the past 20 years has been in household credit can partly explain the insignificant relationship between finance and growth in these countries.

  • A third explanation posits the financial system might actually grow too large relative to the real economy if it extracts excessively high informational rents, and in this way attracts too much young talent towards the financial industry (Bolton et al. 2011, Philippon 2010).

Kneer (2013a,b) provides empirical evidence for this hypothesis, showing that industries relying more on human capital suffer more in their productivity as the financial system expands. This hypothesis thus clearly points to a trade-off between the intermediation function a financial sector provides to the real economy and a drain on talent needed by the same real economy.

Which View of the Financial System?

Related to this last hypothesis is the question on the concept of the financial sector. While academics have focused mostly on the facilitating role of the financial sector, as described so far, policymakers – especially before the crisis and more in some European countries than others – have often focused on financial services as a growth sector in itself. This view towards the financial sector sees it more or less as an export sector, i.e. one that seeks to build an – often – nationally centred financial centre stronghold by building on relative comparative advantages, such as skill base, favourable regulatory policies, subsidies, etc. Based on a sample of 77 countries for the period 1980-2007, Beck, Degryse and Kneer (2014) find that intermediation activities increase growth and reduce volatility in the long-run, while an expansion of the financial sectors along other dimensions has no long-run effect on real sector outcomes. Over shorter-time horizons, a large financial sector stimulates growth at the cost of higher volatility in high-income countries. While these results were obtained for the period before 2007, recent experiences – including the 2008 collapse of the Icelandic banking system and the collapse of the Cypriot banking system in 2012 – have confirmed the high risk of pursuing national financial-centre strategies.

Banking as Put Option

The same mechanism, through which finance helps growth, also makes finance susceptible to shocks and, ultimately – fragility. Agency conflicts, inter-linkages, and herding trends make banking susceptible to aggressive risk-taking and boom-bust cycles. There is thus not only a cross-country variation in the degree to which financial systems are too shallow or too large, but the same variation exists within countries over time. A poorly designed financial safety net, however, can distort risk-taking incentives even further, as was the case in many high-income countries before the Global Financial Crisis (and continues to be, some would argue). Bailout expectations and procyclical regulatory standards can explain an overexpansion of the banking system in good times, and an excessive retrenchment in bad times. Regression analysis that focuses on shorter-term relationships between finance and growth might capture such cyclical behavior, as shown by Loayza and Ranciere (2006).

The Policy Lessons

These findings are interesting not just for the academic debate, but also relevant for the financial reform debate, currently under way across the globe. The different explanations for the insignificant, or even negative relationship recently observed in high-income countries send important policy messages:

  • Policies that refocus the financial system on intermediation, and especially on enterprise credit, can be helpful.
  • This does not imply policies to expand small and medium enterprise (SME) lending in an unsustainable manner, but avoiding policies that favour investment in government bonds or mortgage credit.
  • Policies aiming at creating a financial centre do not necessarily bring long-term growth benefits.
  • This refers especially to tax and regulatory subsidies.
  • Policies that force financial institutions and market participants to internalise the downside risks, including externalities imposed through their failure, can help the financial system grow to a sustainable system. [Also too jail time. –lambert]
  • Such policies do not just refer a resolution framework that bails-in rather than bails-out, but also macroprudential regulation dampening the procyclicality of bank credit.


Finance is a powerful tool for economic development but with important non-linear effects. Critically, poorly designed regulatory framework can reinforce the fragility inherent in financial systems, and cause economic damage. This also implies that the financial sector can grow too large for society’s benefits. Even twenty to thirty years after financial liberalisation, high-income countries still have to learn how to live with the genies they let out of the bottle and harness it to the benefit of their societies.


Aghion, Philippe, Peter Howitt, and David Mayer-Foulkes (2005) “The Effect of Financial Development on Convergence: Theory and Evidence.” Quarterly Journal of Economics 120, 173–222.

Arcand, Jean Louis, Enrico Berkes, and Ugo Panizza (2012), “Too Much Finance?” IMF Working Paper 12/161,

Beck, Thorsten (2009) “The Econometrics of Finance and Growth.” In Palgrave Handbook of Econometrics, vol. 2, ed. Terence Mills and Kerry Patterson, 1180–1211. Houndsmill: Palgrave Macmillan.

Beck, Thorsten (2013), “Finance, Growth, and Fragility: The Role of Government”, CEPR Discussion Paper 9597.

Beck, Thorsten, Berrak Büyükkarabacak, Felix K. Rioja, and Neven T. Valev. (2012), “Who Gets the Credit? And Does it Matter? Household vs. Firm Lending across Countries.” B.E. Journal of Macroeconomics: Contributions 12

Beck, Thorsten, Hans Degryse and Christiane Kneer (2014), “Is More Finance Better? Disentangling Intermediation and Size Effects of Financial Systems”, Journal of Financial Stability forthcoming.

Bolton, Patrick, Tano Santos and Jose Scheinkman (2011), “Cream Skimming in Financial Markets.” National Bureau of Economic Research Working Paper 16804.

Demirgüç-Kunt, Asli and Harry Huizinga (2010), “Bank activity and funding strategies: The impact on risk and returns” Journal of Financial Economics 98, 626-650.

Hasan Iftekhar, Michael Koetter, and Michael Wedow (2009) “Regional growth and finance in Europe: Is there a quality effect of bank efficiency?” Journal of Banking and Finance, 33, 1446–1453.

King, Robert G., and Ross Levine (1993a) “Finance and Growth: Schumpeter Might Be Right.” Quarterly Journal of Economics 108, 717–738.

Kneer, Christiane (2013a) “Finance as a Magnet for the Best and Brightest: Implications for the Real Economy” DNB Working Paper 392.

Kneer, Christiane (2013b) “The Absorption of Talent into Finance: Evidence from US Banking Deregulation”, DNB Working Paper 391.

Levine, Ross (2005) “Finance and Growth: Theory and Evidence.” in Handbook of Economic Growth, ed. Philippe Aghion and Steven N. Durlauf, 865–934. Amsterdam: Elsevier.

Loayza, Norman V and Romain Rancière (2006), “Financial Development, Financial Fragility, and Growth.” Journal of Money, Credit and Banking 28, 1051–1076.

Phillipon, Thomas (2010), “Financiers vs. Engineers: Should the Financial Sector be Taxed or Subsidized?” American Economic Journal: Macroeconomics, 158–82.

1 More recently, several papers have proposed measures of banking-sector quality, focusing on the profit or cost efficiency of financial institutions.

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About Lambert Strether

Readers, I have had a correspondent characterize my views as realistic cynical. Let me briefly explain them. I believe in universal programs that provide concrete material benefits, especially to the working class. Medicare for All is the prime example, but tuition-free college and a Post Office Bank also fall under this heading. So do a Jobs Guarantee and a Debt Jubilee. Clearly, neither liberal Democrats nor conservative Republicans can deliver on such programs, because the two are different flavors of neoliberalism (“Because markets”). I don’t much care about the “ism” that delivers the benefits, although whichever one does have to put common humanity first, as opposed to markets. Could be a second FDR saving capitalism, democratic socialism leashing and collaring it, or communism razing it. I don’t much care, as long as the benefits are delivered. To me, the key issue — and this is why Medicare for All is always first with me — is the tens of thousands of excess “deaths from despair,” as described by the Case-Deaton study, and other recent studies. That enormous body count makes Medicare for All, at the very least, a moral and strategic imperative. And that level of suffering and organic damage makes the concerns of identity politics — even the worthy fight to help the refugees Bush, Obama, and Clinton’s wars created — bright shiny objects by comparison. Hence my frustration with the news flow — currently in my view the swirling intersection of two, separate Shock Doctrine campaigns, one by the Administration, and the other by out-of-power liberals and their allies in the State and in the press — a news flow that constantly forces me to focus on matters that I regard as of secondary importance to the excess deaths. What kind of political economy is it that halts or even reverses the increases in life expectancy that civilized societies have achieved? I am also very hopeful that the continuing destruction of both party establishments will open the space for voices supporting programs similar to those I have listed; let’s call such voices “the left.” Volatility creates opportunity, especially if the Democrat establishment, which puts markets first and opposes all such programs, isn’t allowed to get back into the saddle. Eyes on the prize! I love the tactical level, and secretly love even the horse race, since I’ve been blogging about it daily for fourteen years, but everything I write has this perspective at the back of it.


  1. s spade

    Very evenhanded. You would think this guy spent the past five years on Mars.

    Do we really need academic studies about whether flooding the economy with credit and disregarding the possibilities for repayment produces ‘economic growth’?

    1. from Mexico

      I think we do.

      Since the Enlightenment, it’s the way the game is played. As Hannah Arendt put it in “Karl Marx and the tradition of Western political thought”:

      The tremendous practical advantage of Marx’s “scientific” over utopian socialism was, and still is, that it liberated the socialist movement from its worn-out moralizing attitudes, and recognized that the class quesiton in modern society could not longer be solved by a “passion for justice” or on the basis of a slightly modified Christian charity.

      This is not to poo poo religious or moral arguments. But if the question is asked, “What is needed, moral arguments or scientific arguments?, I would answer that the appropriate answer is: “All of the above.”

  2. Alejandro

    Every time I see or hear the word “efficiency”, I instinctively grab my wallet to make sure it’s still there. More “cognitive” camouflage for what in essence is embezzlement of the commons.

  3. scott

    Not one mention of the fact that finance doesn’t produce wealth, only skims it off the real economy.

    The productivity gains of the last 30 years did not go to the average worker. Instead, their standard of living went down as the FIRE economy went from 10 to 40% of GDP.

    Putting Goldman Sachs into the DJIA kind of explains it all.

    1. Dan Kervick

      Not one mention of the fact that finance doesn’t produce wealth, only skims it off the real economy.

      That’s an extreme statement I think. It’s hard to believe that an economy in which all consumption and investment is self-financed from savings could generate the kinds of growth rates that modern economies have.

      1. susan the other

        Interesting article. I don’t think that the financial industry is guilty of draining away good talent so much as it’s short-sightedness for profit drains away opportunity for growth – and to do so, it expands a barren horizon of opportunity because it looks to the future without creating the future. If we just did a full stop – take five – and looked at oil it would help. It is going to cost a lot to wildcat oil with new techniques and it is going to cost a lot to mitigate CO2 so we can keep using oil. But oil, some say, is still the cleanest energy. I think they are right. Right now everything looks chaotic. Political chaos. Energy chaos. Whatever. Fukushima aside – because it is such a terrifying threat to the planet – we have to base our financial plans on something real. We should never ever lose sight of the fact that everything – everything – is fiat. Everything is political. We can do whatever we want economically, but we will commit suicide if we do stupid things.

      2. diptherio

        There are models for non-extractive finance. Proudhon’s Mutualist banking comes to mind.

        I would add though that “the growth rates that modern economies have” is not necessarily a good yard stick to measure economic success by. I think lots of us feel like growth should be slower and more evenly distributed, rather than faster. I actually wouldn’t mind economic contraction, so long as the contraction is at the top. Just sayin’…

        1. anon y'mouse

          one thing we could use, is a contraction in the idiocy level (and how that manifests in our physical reality) at every level all over the world.

  4. par4

    I disagree. Tokens of make believe “value”(money) are not necessary for any human endeavor. Step back and look at the big picture and realize that all there is is the planet and man’s labors upon it.

    1. Yves Smith

      Go to the back of the class. That’s simply inaccurate.

      As David Graeber documented long form in his book Debt: The First 5000 Years, debt preceded money, and for a very long time at that. And any two parties can enter into a debt agreement: I’ll lend you my car for a day and you’ll cook me dinner in return. You don’t need money to enter into those arrangements.

  5. from Mexico

    This is an outstanding post, and the kind of nuanced and subtle analysis which is needed if there is to be any hope at reforming the finance industry.

    I’d also say it’s more realistic, though perhaps less politically efficacious, than my typical polemic, which is:

    finance = bad

    1. washunate

      Surreal, isn’t it? How does one write a section on policy lessons without addressing bailouts and crime as the two biggest bullet points. There’s even academic language to couch it in, if one desires to be more diplomatic – moral hazard and market failures and rule of law and property rights and so forth.

  6. Hal

    Since i did not take any courses in economics or finance in college, I gave up reading this article about a quarter of the way through.

    Could someone please translate the following sentence into something a layman can understand:

    “the measures of financial depth and intermediation the literature has been using might be simply too crude to capture quality improvements at high levels of financial development.”

    1. craazyman

      It means: “No matter how bad it gets, there’s probably always a way to make it look good, as long as we don’t constrain ourselves to what most people might call objectivity.”

    2. anon y'mouse

      initially or early on, more finance seems to improve the economy.

      at this point, however we’ve been measuring ‘improvement’ in the rest of the economy resulting from additional levels of finance (growth in financial sector?)might be too imprecise a tool to show any ‘real’ improvement.

      conclusion for the reader: either our tools are off, or there isn’t any ‘improvement’ at these levels of finance for the real economy (diminishing marginal returns). we need to refine our tools, or reform our expectations.

      supplemental to conclusion: if proper measurement proves no additional benefits, or perhaps even dis-improvement (is that a word) with higher levels of finance, then perhaps we need to cut the financial sector down to size.

      course, you bring your own conclusions. but those often depend upon how you* read & understand the text.

      *by necessity, subjectively. since everyone’s brains and cognitive processes are different, and because language itself is just a handy tool which can be surgeon-scalpel sharp in the right hands, and blunt hacking hedge-trimmer in the wrong ones (mine).

  7. jfleni

    “What are the reasons for this insignificant or even negative relationship between finance and growth across high-income countries?”

    One simple, if slangy, word:


  8. LifelongLib

    What about financing economic activity through grants of fiat currency rather than loans? Use the same kind of controls we use on grants now to make sure the money is spent for the purposes intended. OK, it’s socialistic and morally hazardous and maybe impossible to administer, but our current system isn’t working either.

  9. avg John

    Shared pain. Tax rates on investments should be anchored to the Main Street economy. When the objectives of full employment and deficit surplus are achieved, reward the financial system in kind with lower capital gains rates, and when the opposite occurs for the general economy and the average American (flat real wage growth), tax the heck out of Wall Street profits and wealth, and lower the tax rates on earned income. Things are not going to change if we continue to print money for the benefit of the .01 %, and they profit so handsomely off the pain of the economic malaise experienced by the average citizen. Let everyone share in the pain and good time alike. (Note: flexibilty can be built into such a tax policy to encourage investment at home at the same time)

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