WHAT IS HAPPENING TO THE IMPACT OF FINANCIAL DEEPENING ON ECONOMIC GROWTH

I. INTRODUCTION Among the strongest elements of the modern economists' canon is that financial sector development has a significant impact on economic growth. A generation ago, economists like Goldsmith (1969) (1) and McKinnon (1973) began to draw attention to the benefits of financial structure development and financial liberalization. By the early 1990s, McKinnon (1991, 12) could write with confidence that: "Now, however, there is widespread agreement that flows of saving and investment should be voluntary and significantly decentralized in an open capital market at close to equilibrium interest rates." Since the 1990s, a burgeoning empirical literature has illustrated the importance of financial sector development for economic growth. Despite the growing consensus, however, we find that the link between finance and growth in cross-country panel data has weakened considerably over time. At the very time that financial sector liberalization spread around the world, the influence of financial sector development on economic growth has diminished. The seminal empirical work that established the growth-finance link is King and Levine (1993), which extended the cross-country framework introduced in Barro (1991) by adding financial variables such as the ratios of liquid liabilities or claims on the private sector to gross domestic product (GDP) to the standard growth regression. They found a robust, positive, and statistically significant relationship between initial financial conditions and subsequent growth in real per capita incomes for a cross-section of about 80 countries. In the subsequent decade numerous empirical studies expanded upon this, using both cross-country and panel data sets for the post-1960 period. (2) In this paper we reexamine the core cross-country panel result and find that the impact of financial deepening on growth is not as strong with more recent data as it appeared in the original panel studies with data for the period from 1960 to 1989. We consider various explanations for this clear shift. First, we suggest that financial deepening has a positive effect on growth if not done to excess. Rapid and excessive deepening, as manifested in a credit boom, can be problematic even in the most developed markets because it can both weaken the banking system and bring inflationary pressures. We test this hypothesis by looking at the finance-growth nexus among countries that have or have not experienced financial sector crises. We find that once crisis episodes are removed, the finance-growth relationship remains intact. Its weakening over time thus seems to be a result of an increased incidence of crises in later years. Our second and related hypothesis is that the widespread liberalization of financial markets that occurred in the late 1980s and early 1990s made financial deepening less effective. This is reminiscent of Robert Lucas's (1975) critique of econometric policy evaluation advanced three decades ago. Policies that have promoted and/or forced increases in financial depth over the past two decades may have altered the basic structural relationship between finance and growth. This could occur if the observed benefits of financial deepening led many countries to liberalize before the associated legal and regulatory institutions were sufficiently well developed. As a consequence, the impact of financial deepening on growth would become smaller. Our evidence does not indicate that recent liberalizations are responsible for the breakdown of the finance-growth link. However, there may be an indirect link as premature financial development can lead to financial crises that have real effects. Third, we examine the role of global equity markets that have grown in importance and prominence in the years over which the finance-growth relationship disappeared. However, we do not find any evidence to suggest that equity market growth has substituted for the role of credit markets and banks in particular. …