Financial Development, Financial Fragility, and Growth

A recent IMF Working Paper by Norman Loayza and Romain Ranciere entitled Financial Development, Financial Fragility, and Growth (http://www.imf.org/external/pubs/ft/wp/2005/wp05170.pdf) tries to disentangle the short run and long run effects of financial development on economic growth.

In the process, the authors also seek to reconcile the apparent contradictions between two strands of the literature on the subject.

“On the one hand, the empirical growth literature finds a positive effect of financial depth as measured by, for instance, private domestic credit and liquid liabilities. On the other hand, the banking and currency crisis literature finds that monetary aggregates, such as domestic credit, are among the best predictors of crises and their related economic downturns. This paper accounts for these contrasting effects based on the distinction between the short- and long-run effects of financial intermediation.”

Essentially, Loayza and Ranciere measure financial development by the ratio of private credit to GDP. Using data for 75 countries from 1960 to 2000, they show that in the long run, a rise in this financial intermediation ratio increases economic growth. However, the short run effect is negative and this effect is several times the long term effect.

In their detailed analysis however the authors show that the short term effect is entirely due to the countries that have experienced a banking crisis. “In fact, for the non-crisis countries, the average short-run impact of intermediation on growth is statistically zero.”

This suggests that it is rather misleading to claim that financial development reduces economic growth even in the short term. First., while the title of the paper uses the term financial development and the text of the paper uses the term financial intermediation, the measure used is purely a measure of credit and ignores other financial claims. Second, the negative impact even in the short term is restricted to crisis countries where presumably the institutional structures required to support rapid credit growth were less well developed.

Posted at 1:21 pm IST on Mon, 12 Sep 2005         permanent link

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