the evolution of the finance- growth nexus paul wachtel stern school of business, new york...
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The Evolution of the Finance-Growth Nexus
Paul WachtelStern School of Business, New York University
Restoring Inclusive Growth in Advanced EconomiesOctober 8, 2010
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Overview
Modern growth theory and development economics ignored finance
Change in 1990sFinance CAUSES growth
Entered the canon of economists beliefsBut, 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
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
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Finance-growth empirical nexus
OriginsGoldsmith (1969), McKinnon (1973)
Empirical groundbreakersBarro, King, Levine, et al – cross country
studiesWachtel, Rousseau – time series studies
Measuring financial developmentSize – depth - of financial sectorRatio of intermediation / GDP
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Average Growth Rate
Financial depth quartile
M3/GDP Credit/GDP
1 Highest 2.81 2.84
2 2.20 2.41
3 1.65 1.21
4Lowest 0.68 0.94
84 countries1960-2004
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Problems with panel evidence
GDP growth
Financial depth
Little within countryrelationship but, large between country differences.
Long time series evidence
Panel data evidence
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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?Deepening over a 5 year period above a
threshold1960-2007 – 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 sectorDid 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 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 1975Median 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 betweenFinancial deepening and growth of financial
sector that improves allocative efficiency and generates economic growth
ANDCredit 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?
Industrialization
Modernization
Digitalization
Credit Booms
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Financial intermediation % of output
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
Korea √ 3.9 6.9
Mexico 3.1 (88) 3.7
Netherlands √ 5.8 7.7
New Zealand 6.4 (86) 6.3 (04)
Norway 3.7 4.0
1985 2005
2005Ireland 9.7Iceland 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 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 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
19th century Lender of last resort Regulate individual banking institutions because of
a concern for systemic risks (called panics) Early 20th 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 20th century Macroeconomic role of central bank emerged
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Central bank history
Late 20th centuryMacro 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.
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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 interestsAsset 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.