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The Evolution of the FinanceGrowth Nexus
Paul Wachtel
Stern School of Business, New York University
Restoring Inclusive Growth in Advanced Economies
October 8, 2010
Overview
Modern growth theory and development
economics  ignored finance
 Change in 1990s
 Finance CAUSES growth



Entered the canon of economists beliefs
But, what do we really know?

When / how is expansion of financial sector
beneficial?
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Growth empirics
Solow introduced framework – 1956
 TFP or Factor accumulation



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Understanding East Asia miracle
Mystics vs. Fundamentalists
Understanding TFP

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Technological progress and knowledge transfers
Experience of Soviet economies
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Resource allocation also important
Finance as a source of allocative efficiency
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Finance-growth empirical nexus

Origins
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Goldsmith (1969), McKinnon (1973)
Empirical groundbreakers
Barro, King, Levine, et al – cross country
studies
 Wachtel, Rousseau – time series studies
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Measuring financial development
Size – depth - of financial sector
 Ratio of intermediation / GDP

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Average Growth Rate
Financial
depth quartile
1 Highest
M3/GDP Credit/GDP
2.81
2.84
2
2.20
2.41
3
1.65
1.21
4Lowest
0.68
0.94
84 countries
1960-2004
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Problems with panel evidence
GDP growth
Long time series evidence
Panel data evidence
Little within country
relationship but,
large between country
differences.
Financial depth
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Can we believe the econometrics?

Broad money to GDP ratio –
Distribution of countries:
⅓ -- < 40%; ⅓ -- 40-60%, ⅓ -- > 60%
 10 percentage point increase in depth
 1 percentage point increase in growth rate

TOO GOOD TO BE TRUE
Makes growth look too easy!
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Case based approach
Ongoing work with Peter Rousseau
---- Episodes of financial deepening and
subsequent growth experience

What is an episode?

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Deepening over a 5 year period above a
threshold
1960-2007 – 144 countries.
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Preliminary evidence
Cut to the chase
Q - Are episodes of financial deepening
followed or accompanied by a sustained
growth spurt?
A - NO.
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Debt/GDP ratio in the US
Ratio increased by about one-third in the 80s
and again in the 00s.
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US deepening episodes

Two deepening episodes
periods of increased financial activity and
innovation in the financial sector
 Did they enhance resource allocation and
lead to economic growth?
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Or, are these simply periods of increased
leverage and risk taking that were
associated with financial crises (market
crash in 1987 and crisis of 2007-08).
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Focus on financial crisis
Identify crises and look at commonalities
in pre and post crisis experience.
 Reinhart and Reinhart (Jackson Hole
2010) - 15 severe crisis since 1975
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Median 10 year pre-crisis increase in bank
credit / GDP --- 38.4 percentage points.
Substantial financial deepening before
every crisis!
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Research problem

How do we distinguish between
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Financial deepening and growth of financial
sector that improves allocative efficiency
and generates economic growth
AND
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Credit booms that increase leverage and
risk taking which often (not always) leads to
financial crisis and recession.
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Perhaps, with different data

Deepening tells us about leverage, amount of
intermediation.
 May not relate closely to the quality of
intermediary activity
 Theoretical work (Philippon, Jovanovic and
Rousseau) relate eras of economic innovation
and technological progress to the growth of
intermediary activity. New, innovative firms
require financial innovations.
 Alternative measure -
Value added in the financial sector
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Financing growth or crisis?
Credit Booms
Digitalization
Modernization
Industrialization
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Financial intermediation % of output
1985
2005
United States
√
6.4 (87)
8.2
Australia
√
7.2 (89)
10.0
Austria
6.0
5.3
Canada
5.2
6.0
Denmark
4.8
5.4
Finland
3.1
2.5
Italy
5.1
4.8
3.9
6.9
3.1 (88)
3.7
5.8
7.7
New Zealand
6.4 (86)
6.3 (04)
Norway
3.7
4.0
Korea
√
Mexico
Netherlands
√
2005
Ireland 9.7
Iceland 10.2
√ = 25% or more
increase
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Problem still stands

Researchers (championed by Levine) that
established the finance-growth nexus
 Were just not the same people as those
looking at crises
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Earlier crises were (e.g. Japan, Scandinavia) were
accompanied by increases in leverage
It was just assumed that bubbles were a different
phenomenon
How little we know!
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Policy implications
What can the research community tell the policy
community?
 Clear benefits of financial sector to less
developed countries – development of market,
credit based economy.
 Implications of deepening or growing financial
sector less clear for highly developed
economies
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Will increased regulatory constraints inhibit the next
wave of technological innovation?
Will increases in financial depth generate larger
and more frequent crises?
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Financial policy for 21st century
Policy needs to have a broader
understanding of the role of the central
bank.
 Crisis has fundamentally changed our
view of the role of a Central bank
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Central bank history
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19th century
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Early 20th century
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Lender of last resort
Regulate individual banking institutions because of
a concern for systemic risks (called panics)
The systemic aspect of central bank responsibility
disappeared in the US (Fed’s failures in the
Depression)
Central bank lending focussed on (individual)
banking institutions
Mid 20th century

Macroeconomic role of central bank emerged
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Central bank history
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Late 20th century
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Macro policy role of central perfected
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Inflation targeting and interest rate policy
conducted by an independent central bank
Bank regulatory role de-emphasized to the
point of disappearance
 And issues of systemic risk (except for
concern about the payments system) never
enters discussions of central bank role.
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Central bank history
One wonders why central bank research
community never addresses the
research question that I posed.
 Late 20th century view  very narrow
focus of bank interests

Asset price inflation and bubbles given little
attention; viewed as an unnecessary
diversion from inflation targeting
 Regulatory activities ignored.

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Implications of crisis
Central banks have three interests
Macroeconomic monetary policy
Regulation of financial institutions
Systemic risks to the financial system
Further,
These three are interrelated and overlapping.
E.g. the macro growth and crisis implications of
financial deepening.
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