Tuesday, February 17, 2015

Credit use is good for growth but accumulated debt is not, so the effect is non-linear

VOX: Financial development and output growth in developing Asia and Latin America: A comparative sectoral analysis by Joshua Aizenman, Yothin Jinjarak, & Donghyun Park:
The Global Crisis put to the fore the possibility that the relationship between financial depth and output growth may be non-linear – the development of the financial sector may benefit the real sector, but only up to a point.1 Beyond that point, further financial development may have no effect or even a negative effect on growth.

The evidence suggests that the level of service flow of financial sector is good only up to a point, after which it becomes a drag on sectoral growth in the sample countries.

Overall, our evidence is consistent with the hypotheses we set forth at the outset, in particular the non-linear effect of financial development on growth and its uneven effect across sectors. In addition, we find that financial depth has a negative effect on manufacturing in East Asia and a positive effect on finance, insurance, and real estate sector in Latin America. Financial efficiency, as measured by lending-deposit interest spread, is positively associated with the growth of finance, insurance, and real estate sector... We also find some evidence of a financial Dutch disease – the faster the growth of financial services and the larger the lending-deposit interest spread, the slower the growth of the manufacturing sector.


1 Boyd and Smith (1992) show that the quality of financial intermediation has first-order effects on capital flows and economic growth, providing a nice interpretation to the Lucas paradox (1992) of capital flowing uphill, a topic that gained even more attention in the context of the global imbalances in the 2000s (see Laura et al. 2003, Ju and Wei 2011 and the references therein). Cecchetti and Kharroubi (2012) study how financial development affects growth at both the country and industry level. They find the level of financial development is good only up to a point, after which it becomes a drag on growth. These results are in line with Rousseau and Wachtel (2011)’s ‘vanishing effect’ – i.e. credit has no statistically significant impact on GDP growth over the 1965-2004 period. Looking at the more recent data, Philippon and Reshef (2013) concluded that at the very high end of financial development, rapidly diminishing social returns may have set in. Aizenman et al. (2013) found that periods of accelerated growth of the financial sector are more likely to be followed by abrupt financial contractions than are periods of slower financial sector growth. Though these studies do not identify the mechanisms associated with the ‘vanishing effect’ of finance, they are consistent with Minsky (1974)’s hypothesis over time that financial deepening may eventually divert financial resources from financing real activities into speculative and ultimately destabilising risky and bubbly yield-seeking financial investments.

Nonlinear? Sure.

The part I like best? Rousseau and Wachtel in the footnote: credit has no statistically significant impact on GDP growth over the 1965-2004 period.

Yeah. Accumulated debt has been excessive since 1965? Yeah.

From the list of references: Rousseau, P, and P Wachtel (2011), “What is Happening to The Impact of Financial Deepening on Economic Growth?” Economic Inquiry, 49, 276-288.

1 comment:

The Arthurian said...

The Rousseau & Wachtel PDF, an older version, dated 2008: