The Evolution of the Finance- Growth Nexus Paul Wachtel Stern School of Business, New York University Restoring Inclusive Growth in Advanced Economies October 8, 2010

2 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?

3 Growth empirics Solow introduced framework – 1956 TFP or Factor accumulation Understanding East Asia miracle Mystics vs. Fundamentalists Understanding TFP Technological progress and knowledge transfers Experience of Soviet economies Resource allocation also important Finance as a source of allocative efficiency

4 Finance-growth empirical nexus Origins Goldsmith (1969), McKinnon (1973) Empirical groundbreakers Barro, King, Levine, et al – cross country studies Wachtel, Rousseau – time series studies Measuring financial development Size – depth - of financial sector Ratio of intermediation / GDP

5 Average Growth Rate Financial depth quartile M3/GDPCredit/GDP 1 Highest Lowest countries

6 Problems with panel evidence GDP growth Financial depth Little within country relationship but, large between country differences. Long time series evidence Panel data evidence

7 Can we believe the econometrics? Broad money to GDP ratio – Distribution of countries: 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!

8 Case based approach Ongoing work with Peter Rousseau ---- Episodes of financial deepening and subsequent growth experience What is an episode? Deepening over a 5 year period above a threshold – 144 countries.

9 Preliminary evidence Cut to the chase Q - Are episodes of financial deepening followed or accompanied by a sustained growth spurt? A - NO.

10 Debt/GDP ratio in the US Ratio increased by about one-third in the 80s and again in the 00s.

11 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? Or, are these simply periods of increased leverage and risk taking that were associated with financial crises (market crash in 1987 and crisis of ).

12 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 Median 10 year pre-crisis increase in bank credit / GDP percentage points. Substantial financial deepening before every crisis!

13 Research problem How do we distinguish between Financial deepening and growth of financial sector that improves allocative efficiency and generates economic growth AND Credit booms that increase leverage and risk taking which often (not always) leads to financial crisis and recession.

14 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

15 Financing growth or crisis? Industrialization Modernization Digitalization Credit Booms

16 Financial intermediation % of output United States √ 6.4 (87)8.2 Australia √ 7.2 (89)10.0 Austria Canada Denmark Finland Italy Korea √ Mexico3.1 (88)3.7 Netherlands √ New Zealand6.4 (86)6.3 (04) Norway Ireland 9.7 Iceland 10.2 √ = 25% or more increase

17 Problem still stands Researchers (championed by Levine) that established the finance-growth nexus Were just not the same people as those looking at crises 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!

18 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 Will increased regulatory constraints inhibit the next wave of technological innovation? Will increases in financial depth generate larger and more frequent crises?

19 Financial policy for 21 st 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

20 Central bank history 19 th century Lender of last resort Regulate individual banking institutions because of a concern for systemic risks (called panics) Early 20 th century 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 20 th century Macroeconomic role of central bank emerged

21 Central bank history Late 20 th century Macro policy role of central perfected 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.

22 Central bank history One wonders why central bank research community never addresses the research question that I posed. Late 20 th 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.

23 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.