What is Happening to the Impact of Financial Deepening on Economic Growth?

Abstract

Although the finance-growth relationship is now firmly entrenched in the empirical literature, we show that it is not as strong in more recent data as it was in the original studies with data for the period from 1960 to 1989. We consider two related explanations. First, excessive financial deepening or too rapid growth of credit may have led to both inflation and weakened banking systems which in turn gave rise to growth-inhibiting financial crises. Second, excessive financial deepening may be a result of widespread financial liberalizations in the late 1980s and early 1990s in countries that lacked the legal or regulatory infrastructure to exploit financial development successfully. We find that the increased incidence of financial crises since the 1990s is primarily responsible for the recent weakening of the finance-growth link, but find no direct evidence that liberalizations played an important supporting role.

Keywords: finance-growth nexus, rolling regression, robustness, cross-country growth