Dynamic effects of financial intermediation over the business cycle

PING WANG [*] This paper provides a empirical evidence that the financial intermediation disturbances can generate business cycles. We examine three countries whose financial sectors are fully developed but quite distinct in their institutional and regulatory circumstances; thus, we can infer whether financial intermediation disturbances differ across dissimilar financial environments. We find that the dynamic responses of output to financial intermediation shocks exhibit similar patterns in all cases studied. However, the various institutional and regulatory circumstances have generated different propagation mechanisms transmitting the financial disturbance to output in ways that lead the magnitudes of the responses to deviate across economies. (JEL E32, E44) I. INTRODUCTION Does the financial sector veil the real economy? Although some economists, such as Lucas [1988] argue that financial factors are "over-stressed," there is a growing literature that theoretically cultivates the channels through which financial intermediation can influence economic fluctuations and long-run growth. Rather than focus on the traditional monetary transmission mechanism, this literature plants itself in the microfoundations of asymmetric information and contract theory. The new financial intermediation literature stems from seminal works by Diamond [1984], Townsend [1983a, 1983b] and Boyd and Prescott [1986] that demonstrate that, in the presence of private information and costly state verification, it is optimal for borrowing and lending to be conducted under financial intermediary arrangements. These ideas were then extended by Williamson [1987] to show how disturbances in the financial intermediation sector can generate business cycle fluctuations. Essentially, when investment projects become more risky or difficult to evaluate, loan supply falls and business cycle movements emerge. [1] Moreover, other financial intermediation impulses are likely to be important as well. These include changes to the institutional framework or the regulatory environment, and any other event that enhances (or hinders) the intermediaries capacity to allocate capital efficiently among competing alternative uses (e.g., financial innovation). Yet, despite the theoretical rhetoric on the importance of financial intermediation to output fluctuations, the empirical relevance of financial intermediation remains an unsettled question. This paper brings us one step closer to the solution by econometrically identifying structural financial intermediation disturbances and estimating their effect on output movements in three major industrialized countries: Germany, the United Kingdom, and the United States. We choose these three advanced economies not only because their financial sectors are fully developed but also because their distinct banking structures and regulatory environments are capable of generating and transmitting financial intermediation disturbances in different ways. That is, the "depth" of financial intermediation is relatively similar across countries. Therefore, the cross-country analysis allows us to focus on the ability of financial intermediation to generate short-run cycles and to draw some suggestive insights regarding the role of regulatory and institutional factors across countries. The existing empirical evidence linking financial factors to real economic activity has involved noticing statistical correlations between some financial variables and some real variables. Goldsmith [1969], using data from 1860 to 1963, showed that there is a positive relationship between economic development and the size of the financial sector. Kuznets [1971], in a cross-section study of 57 developed and developing economies, found that the share of banking, insurance and real estate in gross domestic product rises as income increases. McKinnon [1973] showed that the ratios of private credit to national income and a broad monetary aggregate to national income are positively related to per capita income. …