Nonlinearity in the effects of financial development and financial structure on unemployment

Abstract

The positive role of the financial sector in promoting economic growth has been well established among academics and practitioners since the early 1990s. However, more recently, there has been increasing evidence pointing to a vanishing, and even negative, effect of financial sectors at high levels of financial depth, particularly since the global financial crisis of 2007−2009. Too much finance could hurt growth. The paper shifts the focus towards labor market outcomes by examining whether too much finance also hurts unemployment. Using a dynamic simultaneous model via system GMM estimation and a panel of 97 OECD and non-OECD countries for the period 1991–2015, we find that the answer depends on the type of finance and the extent of a country’s labor market flexibility. Specifically, (i) too much financial development hurts unemployment for countries with more rigid labor markets; (ii) too bank-centered or too little market-oriented financial systems worsen unemployment, particularly for countries with more flexible labor markets; and (iii) too much credit to private enterprises deteriorates unemployment in countries with more rigid labor markets, whereas too little credit to households worsens unemployment in countries with more flexible labor markets. Evidence also shows that these unemployment consequences possibly run through investment and entrepreneurship channels.