The Evolution of the Finance Growth Nexus

This article discusses the historical role of the financial sector in improving allocative efficiency thereby having a positive impact on TFP growth.  However, this article points out that it is difficult to estimate the complicated relationship between financial deepening and economic growth.

Modern growth theory dates back to the mid 1950s, only a little more than 50 years, to the contributions made by Robert Solow and others. Solow’s neoclassical production function approach attributes growth to the quantity of capital and labor inputs and a catchall residual factor called total factor productivity. Productivity studies tended to emphasize capital deepening, improvements in labor quality (human capital investments) and the adoption of new technologies.

The approach reached its zenith in the early 1990s with a controversial literature on the rapid growth of the East Asian economies. Page (1994) distinguishes between the fundamentalist and the mystic explanation for the ‘East Asian miracle’. The fundamentalists stress the role of factor accumulation; they attribute growth to high savings rates and capital accumulation, and human capital development as an educated population moved into the active labor force. The mystics place greater emphasis on the role of the acquisition and mastery of technology. The controversy goes beyond the analytics of the sources of growth. The mystics, unlike the fundamentalists, were likely to support interventionist government development policies. The fundamentalist view of growth in East Asia seems to have won the debate although the argument regarding the efficacy of interventionist industrial policies is as yet unsettled.
Empirical applications of the Solow framework tended to focus more and more attention on total factor productivity (TFP). The great American productivity slowdown in the 1970s and 1980s (the period between the oil shocks and the high tech boom) was attributed to many factors but most analyses were often left with a systematic and striking decline in TFP growth Such a conclusion was very disquieting because it attributed changes in growth rate to a great unknown residual. So, it comes as no surprise that economists began to think about the sources of differences in TFP growth. For example, the fundamentalists were aware of the fact that East Asian resource accumulation was very different than the similarly large levels of accumulation in the Soviet Union and other planned economies. The ability to allocate resources efficiently is hard to measure and, as an omitted variable, would be reflected in TFP growth.
 

An important aspect of allocative efficiency is the role of the financial sector. Although it was not a new idea, it was largely forgotten by development economists who often called for explicit manipulation of financial markets through subsidies, directed credit, interest rate controls and other means in order to achieve development objectives. However, more market oriented discussions of the role of the financial sector, such as Goldsmith (1969) and McKinnon (1973), began to attract attention. The role of financial intermediaries is to bring savers and investors together in a way that directs savings into the most productive investments. The pooling of information and the creation of financial instruments both induces more activity and promotes efficient allocations. Thus, a country with a more developed or more extensive financial system is likely to grow more. The value added by a market oriented financial sector is that it promotes the efficient allocation of resources.
 

This new understanding of the financial sector began to take root about the same time that the fundamentalists and mystics were debating and an empirical literature on the role of the financial sector in economic soon emerged. However, empirical application requires some definition of the role of the financial sector. Quickly, and perhaps mistakenly, the role of financial institutions became to be defined by the size of the sector’s activity. That is an economy with more intermediary activity was assumed to be doing more to generate efficient allocations. So, the level of intermediation to GDP was taken as a broad measure of the size of the financial sector. A simple look at the raw data supported the idea that countries with more intermediation grew more rapidly. The table presents the average growth rates for 84 countries, 1960-2004 for quartiles of two commonly used financial depth ratios, M3 to GDP Total private credit to GDP:

An extensive econometric literature emerged that held constant other determinants of growth and used the most sophisticated techniques to control for the simultaneity of growth and financial depth. Robert Barro (1991) and Robert King and Ross Levine (1993) pioneered the use of cross country panel data to examine the relationship while Paul Wachtel and Peter Rousseau (1995) developed evidence based on long time series for the few countries with available data. The literature grew rapidly and has been eloquently summarized by its champion, Ross Levine, at least three times (1997, 2005, and 2008). By the end of the 1990s, the finance-growth nexus was a well established part of the economic canon.

However, the empirical literature might have over sold the nexus. In Wachtel (2001, 2004), I pointed out that it is misleading to draw inferences about policy objectives from the strong cross country results. First, there is wide variation in the level of financial depth among countries with similar levels of GDP per capita. Second, the between country variation is much larger than the within country variation even over long periods of time. Thus the variation in financial depth seems to be related to differences in institutional structures among countries. As a consequence it is a mistake to draw any causal inferences from the estimated effects of financial deepening on economic growth.

For example, domestic credit to the private sector is typically about 40% in middle income countries (e.g. 36% in Costa Rica with real GDP in 2005 dollars of about $9000) and typically over 100% in high income countries (e.g. 90% in Israel, 125% in New Zealand and 178% in Canada). The cross section estimates of the effect of financial deepening on growth indicate that at an increase in 50 percentage points will increase growth rates by one percentage points. This is a very large effect, so large that concern about reverse causality seems reasonable. Perhaps, following Joan Robinson, enterprise leads and finance follows.

The experiences of individual countries are also difficult to interpret. The development of the American financial system in the late 19th century was instrumental in understanding growth but 20th century developments are harder to understand. The chart shows the increase in financial depth in the US over the last 50 years; it presents the ratio of end of year Flow of Funds data for Debt Outstanding of the Domestic Nonfinancial Sectors (FRED series TODNS) to GDP (FRED series GDPA) from 1960 to 2009. There have been two recent episodes of financial deepening in the US. The ratio increased by about a third in the 1980s and again in the 2000s, otherwise there is little movement. How should we interpret these episodes? Do they represent periods of financial innovation and deeper financial activity which improved resource allocation and contributed to the growth of the economy? Or do they represent periods of increased leverage and risk taking which only temporarily increases growth and can precipitate financial crises. In the first instance, the stock market crash in 1987 did not have widespread macro consequences but in the second instance, the housing crash in 2007 did.

Both the Asian financial crises in 1997 and the global financial crisis in 2007 have brought the role of financial deepening under closer scrutiny. Reinhart and Reinhart (2010) look at 15 late 20th century severe financial crises (including emerging market, the Asian experience and advanced economies such as Japan and the Scandinavian banking crises). They describe the commonalities of the 10 year pre-crisis periods. In each instance there was a surge in the ratio of domestic bank credit to GDP prior to the crisis. The median increase was 38.4 percentage points and the deleveraging in the post-crisis decade was about the same proportional size. The run up of the credit to GDP ratio in the decade prior to the 2007 in the 9 countries that experienced systemic crisis was even larger, about 60 percentage points.

The role of credit deepening as a possible cause of crisis is found earlier in Sachs and Radelet (1998) in their analysis of financial crises in emerging market countries. A significant variable in their probit model to predict severe reversals in capital flows is the ‘private credit buildup,’ the increase over three years in the ratio of private sector financial claims to GDP. Financial depth is a bit of a chameleon; in some contexts it is a determinant of economic growth and in another it is a precursor of crisis. As Peter Rousseau suggested to me, one person’s salubrious deepening is another person’s financial crisis.

Even without a financial crisis, there are difficulties in interpreting financial deepening experiences. Consider the case of Croatia where monetary stabilization and the end of hostilities led to rapid growth of intermediation in the late 1990s. By all accounts, this was viewed as a desirable deepening. However, a banking crisis in 1998-99 led to a contraction of credit. The banking crisis was short-lived and within a year there was a consolidation of the banking sector and privatization to foreign owners. A second credit boom ensued in and by 2006 domestic credit to the private sector exceeded 70% of GDP, more than double the level of decade earlier but still not unusually high for a middle income country. The Croatian National Bank responded to the rapid growth in lending by putting a tax on rapid lending growth and a marginal reserve requirement on foreign borrowing. There was considerable effort to distinguish between the gradual deepening of the financial sector and rapid loan growth.
 

The financial sector’s influence on economic growth is a complex phenomenon. The issue at hand may not be the finance-growth nexus per se but how we measure it. Aggregate data on credit to GDP ratios are useful because it is possible to abstract from national institutions and make formal cross country comparisons. But, the recent experiences described here make abundantly clear that the financial depth ratios are a poor description of the finance growth nexus.
 

As noted the use of financial depth ratios (and generalizations such as adding the ratio of equity market capitalization to GDP) are a matter of convenience. Theoretical arguments about the role of the financial sector relate to the amount or quality of intermediary activity which need not be related to financial depth. My NYU colleague, Thomas Philippon (2008) examines the share of the financial sector in GDP in the US going back over 100 years. The chart shows that there have been several periods of rapid increase in the share. With one exception, Philippon associates these bursts in activity with periods of innovation when young, cash-poor firms require finance:
 

“The financial industry was around 1.5% of GDP in the mid-19th century. The first large increase between 1880 to 1900 corresponds to the financing of railroads and early heavy industries. The second big increase between 1918 and 1933 corresponds to the financing of the Electricity revolution, as well as automobile and pharmaceutical companies…After a continuous collapse in the 1930s and 40s, the GDP share of finance and insurance industries was down to only 2.5% of GDP in 1947. It recovered slowly and was mostly stable at around 4% until the late 1970s, and then grew quickly to reach 8.3% of GDP in 2006. The third large increase, from 1980 to 2001, corresponds to the financing of the IT revolution.”

The one exception of course is the rapid after 2002. Philippon’s modeling suggests that there was a bubble in this period resulted in a financial sector that was about 10% larger than justified by economic fundamentals.

Looking at the specific activities of the financial sector and their contribution towards growth is even more difficult. Financial innovations (e.g. derivatives, securitization, etc.) are valued because they facilitate the functioning of the sector. However, empirical analysis to evaluate the impact of specific activities is so far elusive. A comment made by Paul Volcker in December 2009 has been widely quoted in this regard:

“I wish somebody would give me some shred of evidence linking financial innovation with benefit to the economy.”
 

The ATM is the one innovation in the past 25 years that he was willing to cite:
 

“It really helps people. It’s useful.”
 

Two years past the global meltdown, where does the finance-growth nexus stand? All in all, it is relatively unscathed. What we have learned is not that finance is unimportant but, instead, we have learned how difficult it is to measure financial sector activity properly.

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