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Financialization and Economic Performance

The intention of this section is to provide an overview of the empirical work, which bears on the question of the relationship between finan- cialisation and economic performance. This includes the growth of the financial sector and growth, the occurrence and costs of financial crisis, financial liberalization and growth, the pursuit of shareholder value and investment, and financialization and inequality.

Finance and Growth

There is a long-standing set of literature on the relationship between the size of the financial sector (often summarized in terms of ‘financial development’ and ‘financial deepening’) and the pace of economic growth.

The growth of the financial sector has often been evaluated under terms such as financial development, financial deepening, and the perceived role of financial development as a promoter of savings and investment (in terms of raising the level of savings through the provision of liquidity and financial assets, an assumed causal relationship from savings to investment, and the monitoring roles of financial institutions).

There has been a long-standing literature on the relationships between financial development and deepening and economic growth. Financial deepening, often measured by variables such as bank deposits to GDP, focuses on the growth of the formal financial sectors and also the variables used are dimensions of financialisation. That literature has generally found a positive relationship between financial development and economic growth, though the causal relationships involved are matters of debate. A more recent literature has tended to find a much weaker relationship, and often finding an inverted U-shaped relationship such that industrialized countries are often operating on the negative part of the curve.

Levine (2005), in his extensive review of the empirical literature, concluded that “a growing body of empirical analyses, including firm-level studies, industry-level studies, individual country-studies, time-series studies, panel-investigations, and broad cross-country comparisons, demonstrate a strong positive link between the functioning of the financial system and long-run economic growth. While subject to ample qualifications and countervailing views noted throughout this article, the preponderance of evidence suggests that both financial intermediaries and markets matter for growth even when controlling for potential simultaneity bias. Furthermore, microeconomic-based evidence is consistent with the view that better developed financial systems ease external financing constraints facing firms, which illuminates one mechanism through which financial development influences economic growth. Theory and empirical evidence make it difficult to conclude that the financial system merely—and automatically—responds to economic activity, or that financial development is an inconsequential addendum to the process of economic growth” (p. 921).

Arestis et al. (2015) conducted a meta-analysis of the empirical evidence on the effects of financial development on growth. They conclude that in terms of the correlations between financial development and growth the usage of market-based proxies of financial development appear to lead to lower correlations than the use of either liquid liabilities or market-based variables. However, “the estimated coefficients of bank- based measures and complex indices are found statistically insignificant in all specifications. ... Additionally, panel data, which are frequently used from the late 1990s onwards, produce smaller correlations. The same seems to hold for time series. ... [H]owever, the results suggest the existence of a statistically significant and economically meaningful positive genuine effect from financial development to economic growth” (pp. 557-9).

Valickova et al. (2015), based on an examination of 67 studies on financial development and economic growth, conclude that “the studies imply a positive and statistically significant effect [of financial development on growth], but the individual estimates vary widely” (p. 506). They report that the effect appears to be weaker in less developed countries and to decrease across the globe after the 1980s. Further, they suggest that stock markets enable faster economic growth as compare with other financial institutions.

Bezemer et al. (2016) analyse data from 46 countries over the period 1990-2011, observing that financial deepening supports investments and the reallocation of factors of production between sectors. However, they find that a large credit-to-GDP ratio can be a drag on growth, with rising credit-to-GDP ratios coinciding with shifts in the composition of credit towards real estate and other asset markets and hence away from investment in productive assets. They “find that the growth coefficient of different credit stocks scaled by GDP is insignificant or negative, especially credit stocks supporting asset markets. We observe insignificant or negative correlations of credit stocks with output growth. . The positive effect of credit flows diminishes at higher levels of financial development. ... Bank credit has shifted away from nonfinancial business toward asset markets, where it has no or small growth effects” (p. 667).

Authors have reported on at least some weakening of the links between financial deepening and economic growth. Rousseau and Wachtel (2011) argue that “we show that it [the finance-growth link] is not as strong in more recent data as it was in the original studies with data for the period from 1960 to 1989” (p. 276). Arcand et al. (2012) “use different empirical approaches to show that there can indeed be ‘too much’ finance. In particular, our results suggest that finance starts having a negative effect on output growth when credit to the private sector reaches 100 % of GDP We show that our results are consistent with the ‘vanishing effect’ of financial development and that they are not driven by output volatility, banking crises, low institutional quality, or by differences in bank regulation and supervision” (p. 1).

Cecchetti and Kharroubi (2012)[1] reached two significant conclusions. The first is that the size of the financial sector has an inverted U-shaped relationship with productivity growth and that after some point the further enlargement of the financial sector tends to reduce growth. They interpret these findings in terms of a large financial sector drawing scarce resources away from the rest of the economy and the adverse effects of financial booms and busts on growth. They conclude that “more finance is definitely not always better” (p. 14).

Beck et al. (2013) find that while in the long run financial intermediation increases growth and reduces growth volatility, both effects have become weaker over time. However, they find that “The size of the financial sector while controlling for the level of intermediation in an economy does not seem to affect long-run growth or volatility. Our analysis also shows that neither the size of the financial sector nor intermediation is associated with higher growth in the medium run” (p. 13).

Sahay et al. (2015) use a broad, measure of financial development, and find that the effect of financial development on growth is inverted U-shaped, with the effects weakening at the higher levels of financial development, coming from financial deepening rather than from greater access or higher efficiency. The weakening effect is viewed as impacting on total factor productivity rather than on the accumulation of capital. When the pace of financial development is relatively rapid then financial deepening can lead to economic and financial instability.

Cournede et al. (2015) in an OECD study note that “over the past fifty years, credit by banks and other intermediaries to households and businesses has grown three times as fast as economic activity”. Based on 50 years of data for OECD countries, they conclude (p. 6) that further growth of the financial sector as far as most OECD countries are concerned is likely to slow down the rate of economic growth rather than raise it.

The particularly significant view to arise from the recent literature is that the previous findings of positive relationships between financial development and more generally the size of financial sector with economic growth has weakened and often turned negative. As such, these more recent findings feed into the idea that the financial sector may have become too large.

  • [1] For other studies see, for example, Barajas et al. (2012, 2013), Rioja and Valev (2004, 2005),Aghion et al. (2005), Dabla-Norris and Srivisal (2013).
 
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