Alan Greenspan, former chairman of the Federal Reserves, had placed capital market development as a central factor in determining severity of output contraction during an Asian financial crisis. In his speech, Greenspan (2000) argued forcefully that countries that have a strong banking system plus robust capital markets can better withstand financial crises than those countries that have only one or the other.
He argued further that the most important buffer against financial stress is the development of alternatives that enable financial systems under stress to maintain an adequate degree of financial intermediation should their main source of intermediation, whether banks or capital markets, freeze up in a crisis.
In contrast to the large and growing literature on the impact of finance and growth [e.g. Demirguc-kunt and Levine (2001)], theoretical and empirical work on the relationship between finance and various aspects of business cycles has been relatively scarce, and even fewer papers on the effects of capital markets.
This gap in the current research is quite surprising given the importance of business cycles in the study of macroeconomics. This paper extends previous research in this field by empirically investigating the effects of capital markets on certain aspects of business cycles, namely severity of business cycles, and probability of an economic downturn.