Abstract
This paper reviews the evolving literature that links financial development, financial crises, and economic growth in the past 20 years. The initial disconnect -- with one literature focusing on the effect of financial deepening on long -- run growth and another studying its impact on volatility and crisis?has given way to a more nuanced approach that analyzes the two phenomena in an integrated framework. The main finding of this literature is that financial deepening leads to a trade-off between higher economic growth and higher crisis risk; and its main conclusion is that, for at least middle-income countries, the positive growth effects outweigh the negative crisis risk impact. This balanced view has been revisited recently for advanced economies, where an emerging and controversial literature supports the notion of too much finance, suggesting that there might be a threshold beyond which financial depth becomes detrimental for economic growth by crowding out other productive activities and misallocating resources. Nevertheless, the growth/crisis trade-off is alive and strong for a large share of the world economy. Recognizing the intrinsic trade-offs of financial development can provide a useful framework to design policies targeting financial deepening, diversity, and inclusion. In particular, acknowledging the trade-offs can highlight the need for complementary policies to mitigate the risks, from financial macroprudential policies to monetary policy frameworks that monitor the growth of credit and asset prices.
Highlights
Introduction and BackgroundFinance is the fuel of economic growth
The initial disconnect, with one literature focusing on the role of financial depth on long-run growth and another studying its impact on volatility and crisis, has given way to a more nuanced literature that analyzes the two phenomena in an integrated framework
The main finding of this literature is the existence of a trade-off between higher growth and higher crisis risk and the conclusion that, for at least middle-income countries, the positive growth effects outweigh the negative crisis risk impact
Summary
Finance is the fuel of economic growth. Yet, the same fuel, when excessive and triggered by a shock of flame, can engender an economic crisis. There is no evidence, that a high ratio of credit to GDP by itself is associated with higher macroeconomic volatility This latter result is consistent with the notion that rapid growth of credit rather than high level of financial development increases crisis risk (Schularick and Taylor, 2012). Using industry-level data, Levchenko, Ranciere and Thoenig (2009) provide more support to the third hypothesis, by showing that finance has a strong effect of reducing industry mark-ups and has the potential to lift the economy towards a higher (less distorted) steady state Another explanation for the vanishing effect is the view that certain financial activities crowd out more productive ones and result in a misallocation of talent in the economy that is detrimental to growth. From a policy perspective, the challenge is to find the kind of financial regulation and supervision that can, first, minimize the trade-off between higher growth and higher risk, and second, generate positive effects on growth and stability by expanding the quality of financial services from a social standpoint
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