This paper analyzes the apparent contradiction between two strands of the literature on the effects of financial intermediation on economic activity. On the one hand, the empirical growth literature finds a positive effect of measures of private domestic credit and liquid liabilities on per capita GDP growth. This is interpreted as the growth enhancing effect of financial development (e.g., King and Levine, 1993; Levine, Loayza, and Beck, 2000). On the other hand, the banking and currency crisis literature finds that monetary aggregates, such as domestic credit, are among the best predictors for crises (e.g., Demirguc-Kunt and Detragiache 1998 and 2000; Gourinchas, Landerretche, and Valdés, 2001; Kaminsky and Reinhart, 1999). Since banking crises usually lead to recessions, an expansion of domestic credit would then be associated with growth slowdowns.
A similar divide exists at the theoretical level. According to the endogenous growth literature, financial deepening leads to a more efficient allocation of savings to productive investment projects (see Greenwood and Jovanovic, 1990; Bencivenga and Smith, 1991). Conversely, the financial crisis literature points to the destabilizing effect of financial liberalization as it may lead to an unduly large expansion of credit. Overlending may occur owing to a number of factors, including a limited monitoring capacity of regulatory agencies, the inability of banks to discriminate good projects during investment booms, and the existence of an explicit or implicit insurance against banking failures (Schneider and Tornell, 2004; Aghion, Bacchetta and Banerjee, forthcoming). Not surprisingly, each strand of the literature has produced its own set of policy implications. Thus, researchers who emphasize the findings of the endogenous growth literature advocate financial liberalization and deepening (e.g., Roubini and Sala-i-Martin, 1992), whereas those who concentrate on crises caution against “excessive” financial liberalization (e.g., Balino and Sundarajan, 1991; Gavin and Hausmann, 1995).
This paper contributes to the debate on the effects of financial deepening from an empirical perspective. First, we highlight the contrasting effects of financial liberalization and credit expansion on economic activity. Second, we attempt to provide an empirical explanation for these contrasting effects. In particular, on the one hand, we relate the positive influence of financial depth on investment and growth to the long-run effect of financial liberalization; but, on the other, we identify a link between the negative impact of financial volatility and crisis and the short-run effect of liberalization. Although it is not our aim to test competing theories, our empirical results provide support to some recent theoretical models predicting that financial liberalization can generate both short-run instability and higher long-run growth.
Contents
I. Introduction
II. Short-and Long-Run Growth Effects of Financial Intermediation
- A. Methodology
B. Data and Results
III. Financial Fragility, Alongside Financial Depth, in the Path to Financial Development
- A. Theoretical Discussion
B. Analysis of Short-Run Coefficients
C. Classical Growth Regressions: The Role of Financial Volatility and Crises
D. Data and Methodology
E. Results
IV. Conclusions
References
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