More Finance, More Growth? More Finance, More Crises?

Yves here. In a bit of synchronicity, this post provides yet more support for an argument we made in our post today on the Wikileaks release of the super-secret section of the Trade in Services Agreement on financial services: that the growth of finance, particularly the great increase in international capital flows, has been destabilizing.

By Simon Sturn and Gerald Epstein, professor of Economics and a founding Co-Director of the Political Economy Research Institute (PERI) at the University of Massachusetts, Amherst. Cross posted from Triple Crisis

A large body of cross-country time-series literature shows that financial development—predominantly measured by private credit as a percent of GDP—fuels growth. But, in light of the many recent episodes of finance driven crisis, these results seem curious. Haven’t we seen that periods of rapid credit expansion are also often periods of economic crisis?

The answer to this puzzle might have to do with the time horizon under consideration. A broad theoretical literature argues that credit demand and supply are correlated with growth in the short-run. Credit demand is “pro-cyclical”—firms are reluctant to borrow and invest during business-cycle slumps, periods of low demand and high uncertainty, while the opposite is true for business-cycle booms. Credit supply is also pro-cyclical, as banks are less willing to lend during recessions, when banks have less capital and borrowers have lower net worth, than during upturns.

Finance and growth, then, are correlated in the short run, but this does not imply that finance also causes long-run growth. Therefore, it is crucial to address the short-run pro-cyclical fluctuations of credit in empirical studies on the impact of finance on growth. Otherwise, the true long-run growth effect of financial development will be overstated.

How Long is the “Long-Run” in the Empirical Literature?

The standard literature on finance and (long-run) growth does not entirely ignore this possible problem, but as we show in our paper these approaches are not up to the task.

The “by-now-standard approach” to deal with short-run fluctuations in the empirical cross-country time-series literature is to transform annual data into five-year non-overlapping periods, which allows one “to focus on long-run economic growth.”

But it is doubtful that five year averaging should purge short-run fluctuations from the data. In fact, according to NBER’s Business Cycle Dating Committee, the average business cycle in the United States from 1960 to 2009 lasted about 6½ years, with the shortest cycle about 2 years and the longest around 11 years. The Euro Area Business Cycle Dating Committee finds an average length of the business cycle of 9½ years since the mid-1970s, with a minimum of nearly 4 years and a maximum of more than 1½ decades. Also, the output gap measures constructed by the OECD and IMF for several rich countries show business cycles between 2 and 15 years of length. Averaging the data over five-year periods is therefore unlikely to smooth out cyclical variations in growth.

Purging Business-Cycle Effects

We address this methodological shortcoming and re-estimate the impact of finance on growth in a dynamic panel data regression set-up for 130 countries over the period 1965 to 2009. We explicitly purge business cycles by including different measures of the output gap, which is the difference between current output and output growing at its trend growth rate.

This is what we find: First, once short-run fluctuations are explicitly purged, the impact of finance on growth is consistently and significantly smaller. This suggests that much of the previous literature following the “by-now-standard approach” overstates the true effect of finance on long-run growth. Their results are contaminated by short-run fluctuations of growth and credit over the business cycle.

Second, we confirm the finding of previous literature that the effects of finance on economic growth become much lower once observations for more recent years are included in the sample. For example, we find that finance boosts economic growth significantly if the sample is estimated until 1989, but not when estimated until 1999 or 2009. This suggests that something in the finance-growth nexus has changed. Perhaps this is the creation of more destructive and predatory forms of finance in recent decades?

Third, our results are consistent with those of several recent papers which argue that financial development measured as private credit increases growth initially, but its effect diminishes and even turns negative at a level of about 90 percent of GDP, which is reached by many developed countries.

In sum, the conventional wisdom among economists that finance boosts growth may mainly reflect results from the pre-financial-markets-liberalization area, combined with a mistaken statistical approach. In fact, our results confirm that the positive finance-growth relationship started to vanish decades ago, not only with the recent crisis.
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  1. Nicholas Shaxson

    To say that ‘growth isn’t as high as people had thought,’ while useful, may be understating the problem. You might have referenced a few other things re finance turning negative above a certain point. Ex UK FSA chair Howard Davies had a useful piece recently, referencing plenty of other research

    Also I’ve written a book about the “Resource Curse” afflicting mineral-rich economies, and a second one about tax havens and financial centres, and I’ve been struck by the many similarities between a dominant oil sector and a dominant financial centre, in terms of the domestic disappointments and harms that can ensue. A colleague and I have been talking about a “Finance Curse” – which makes the comparison explicit.

    1. fresno dan

      that’s a good article full of good points.
      However, I think it misses the real problem. There has been GDP growth since the great recession, and supposedly GDP gotten back above where it was in 2008. But the vast overwhelming majority of the growth has gone to the 0.01 %
      If you continuously make more and more of the economy finance, in which only the very, very rich can play, provide them with free money, and when they lose it, forgive their debts, well I think it is obvious why the economy doesn’t perform well for most people

  2. Ben Johannson

    The paper itself is worth reading. Important to take away that credit is entirely pro-cyclical, expanding during booms and contracting during busts; finance is a follower rather than a leader in the business cycle.

    1. MikeNY

      Yes, my personal experience confirms this: CC offers in the mail completely dried up in 2009-10, but are once again a tsunami…

  3. craazyman

    Fortes Fortuna Audiuvat

    there was certainly a time in my life when the more money I was given the worse things got. My plans for spending were ludicrously fantastical schemes that so-defied probability of success the money might as well have burned like leaves under an autumn sky. The schemes seemed good ideas at the time and there were ways of viewing them as romantic visions sure to end in a glorious and redemptive conquest, ways that only magnified themselves as the contours of the inevitable culmination of these dreams became undeniable to a rational faculty, “If a man’s reach can’t exceed his grasp, then what’s a heaven for.” Somebody wrote that, I think maybe Carlyle. He obviously wasn’t a lender. Or maybe he could have been a modern lender, since heaven is wide open to anyone inspired enough to have a vision and brave enough to borrow to fund it. Fortune favors the brave. It’s amazing that groaf has stalled as debt has climbed. There must be some mistake in the data or the math. It couldn’t be the dreams themselves, since those are never wrong, only deferred until you can find the money.

    1. Eleanor

      “A man’s reach should exceed his grasp, else what’s a heaven for?” is from the poem “Andrea del Sarto” by Robert Browning. It refers to painting, not finance.

      1. craazyman

        I know Andrea del Sarto was a painter, but I didn’t realize he had such long arms! :-)

        Those were the days, when the painting of a man looked like a man. Those were also days when it was hard to get a loan, unless you had heaven by the short hairs and charged admission to people like you and me. If we couldn’t pay it back, we were using our long arms in a galley rowing. Maybe not much has changed, metaphorically speaking.

    2. Jim Haygood

      ‘It’s amazing that groaf has stalled as debt has climbed.’

      While the real economy is governed by the dismal science of scarcity, the magic of free money has untethered financial assets to deliver limitless returns.

      This is the alchemists’ dream come true, of turning the sow’s ear of unemployment and want into the shiny silk purse of a high and rising equity premium.

      Quantitative Exorbitance — for the greater good!

      1. susan the other

        back to sustainability, aka self-sufficiency at some level; just wondering what happens if one nation becomes by law non profit and enforces profit taking and profiteering.

  4. Eeyores enigma

    DEBT/finance is the scoop that scoops up the sugar and sprinkles it over the yeast. As long as there is an ever increasing source of sugar (Fossil Fuel-FF) you can increase the amount of yeast (human society) to sprinkle it on.

    If there are constraints to the sugar supply there WILL be constraints to the amount of yeast. Adding more scoops doesn’t resolve the sugar supply constraints in fact it accelerates them.

    Debt and finance did fine so long as we had constant FF fueled growth as it was able to be serviced for the most part. Ultimately we grew debt/finance (adding scoops) faster than we grew the FF supply.

    Now all anyone can talk about is the scoops and how we can manage them in order to get the yeast growing again without growing the sugar supply. Silly economist tricks are for kids.

  5. Jim Haygood

    ‘a dynamic panel data regression set-up for 130 countries over the period 1965 to 2009’

    All well and good. But though the data becomes spottier before then, it would be preferable to analyze the smaller subset of countries with available and estimated GDP data going back to the 19th century.

    Groaf did just fine in the late 19th century, even with (or perhaps because of) hard money deflation. Fiat currency came to America in 1913. World War I, a brief depression (1920-21), a destructive boom (1921-1929), twelve years of depression (1929-1941) and four years of wartime rationing and financial repression followed. Analyze this!

  6. susan the other

    The planet is conservative, unless it is hit by another planet. The laws of physics are so conservative that they are immutable. So humans trying to jump the shark economically just doesn’t work. And when human ecology gets so out of balance between rich and poor, creating epic inequality, it too converges back to reality. So since we are not all gonna be rich and disgusting, that only leaves one other option.

  7. masterslave

    The bigger problem is not that “” we are not all gonna be rich and disgusting “” but that we cannot even get our “fair share” of the pie . Unfairness has been baked-in-the-cake for hundreds of years and is rooted in biblical mythology . The best way to see the unfairness is to look at an ideal Bell Curve distribution ( aka the Universal Law of the Standard Normal Distribution [ a mathematicly defined and scientificly derived curve ] of virtually anything and everything ) of income and compare it to the actual distribution for a reasonably homogeneous subset of population . Then you have something specific to challenge on the grounds of justification instead of the inferred vague ambiguities of “wealth inequality” ( aka whinings ). You would see how governments unjustifiably disrupt standard normal distributions . Now you got something concrete to fight about . Let’s roll .

    1. A Real Black Person

      To expand on what masterslave has said, from the observations of science, Nature, the natural world, is definitely “unfair” and inequality is baked into life itself. The eternal question, which has yet to be answered one way or the other: Are human created environments such as economies more fair or less fair than natural ones? Nature, contrary to human mythologies, does not “care” if a human lives, dies, pays taxes or practices any faith. Nature adheres to a systems of checks and balances that allows it to be sustainable and that means various organisms must suffer in order for life to continue.

  8. Roland

    I wonder whether what in developing economies we derisively refer to as the “middle-income trap” is not in fact the natural default condition of modernity wherever costs cannot be externalized.

  9. washunate

    It continues to amaze me how much verbage is spewed about finance with using the interesting f word – fraud.

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