Finance and Growth

The rough consensus until recent years has been that finance increases growth. The great recession has led a number of researchers to revisit that result and several papers now report that finance increases growth just up until a point and then turns negative. William Cline, however, has a short but elegant rebuttal. Using the same basic methods, Cline finds that doctors per capita, R&D technicians per capita, and fixed telephone lines per capita all show a positive effect on growth when GDP is low but a negative effect when GDP is high.

Before you turn on your thinking hats to “explain” these results consider that growth tends to slow as GDP increases (moving from catching up to cutting edge growth) and some of the growth slowdown is inevitably picked up by a quadratic term in some other variable that is increasing.

Cline summarizes:

The recent studies’ finding that “too much finance” reduces
growth should be viewed with considerable caution. The reason
is that there is an inherent bias toward a negative quadratic term
in a regression that incorporates financial depth, or any other
variable that tends to rise with per capita income, along with
the usual convergence variable (logarithm of per capita income)
in explaining growth. That the results may well be unreliable is
demonstrated here by finding a statistically significant negative
quadratic term in equations that “explain” growth by spurious
influences: doctors per capita, R&D technicians per capita,
and fixed telephone lines per capita. In some situations, finance
can become excessive; the crises of Iceland and Ireland come
to mind. But it is highly premature to adopt as a new stylized
fact the recent studies’ supposed thresholds beyond which more
finance reduces growth.

Hat tip: Greg Ip.

Addendum: The authors of one of the key papers reply.


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