This paper examines whether there is a threshold above which financial development no longer has a positive effect on economic growth. We use different empirical approaches to show that there can indeed be “too much” finance. In particular, our results suggest that finance starts having a negative effect on output growth when credit to the private sector reaches 100% of GDP. We show that our results are consistent with the “vanishing effect” of financial development and that they are not driven by output volatility, banking crises, low institutional quality, or by differences in bank regulation and supervision. This paper reexamines the relationship between financial depth and economic growth. It reproduces the standard result that, at intermediate levels of financial depth, there is a positive relationship between the size of the financial system and economic growth, but it also shows that, at high levels of financial depth, more finance is associated with less growth. This non-monotonic relationship between economic growth and the size of the financial sector is consistent with the hypothesis that there can be “too much” finance and can explain the recent finding of a vanishing effect of financial depth on economic growth. The idea that a well-working financial system plays an essential role in promoting economic development dates back to Bagehot (1873) and Schumpeter (1911). Empirical evidence on the relationship between finance and growth is more recent. Goldsmith (1969) was the first to show the presence of a positive correlation between the size of the financial system and long-run economic growth. He argued that this positive relationship was driven by the fact that financial intermediation improves efficiency rather than the volume of investment (this is also the channel emphasized by Greenwood and Jovanovich, 1990, and Bencivenga and Smith, 1991). However, Goldsmith made no attempt to establish whether there was a causal link going from financial depth to economic growth. Several economists remained thus of the view that a large financial system is simply a by-product of the overall process of economic development. This position is well-represented by Joan Robinson’s (1952) claim that: “where enterprise leads, finance follows.”
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Document Type | General |
Publish Date | 17/11/2012 |
Author | Updating by ACASH is in process |
Published By | International Monetary Fund (IMF) |
Edited By | Tabassum Rahmani |