Theory and Evidence on the Finance-Growth Relationship: The Virtuous and Unvirtuous Cycles

Abstract

Since the 1980s, financial crises have tended to reoccur with increasing frequency and growing intensity. They are endogenously generated by the established OTD (Originate-To-Distribute) model within the new finance-growth paradigm. Good finance fosters the correct allocation of financial resources, the fair redistribution of wealth and positive economic growth (the virtuous cycle), whereas bad finance captures part of the created wealth and, thanks to a highly technologically advanced financial system with the ability to create money ex nihilo, over time it drags the economy down to recession or negative growth, destroying wealth and consequentially social welfare (the unvirtuous cycle). Therefore, structural factors are at the foundation of the persistence of instability and thus of what we define as the unvirtuous cycle, which can generate what we label the wealth trap. A VUC index has been developed by us to capture the status quo of the finance-growth relationship. A cross-country analysis for the US, UK and Euro area economies has been made in order to verify the validity of the index. A core variable is identified: the degree of financial innovation. This is an endogenous variable within the endogenous money/credit creation process; its identification is of crucial importance, as it is the key to full understanding of the finance-growth relationship and is the element of originality in this field of studies. The VUC index for all countries shows clearly the exponential effect of the degree of financial innovation over time. It is important for scholars and policymakers to understand the mechanism underpinning the finance-growth relationship and that it is their responsibility to return the economic system to what we will call the virtuous cycle.

Keywords: Finance, Growth, Business Cycle, Financial Innovation, Regulatory Dialectic, Financial Power

JEL Classification: E44, E32, E50, E51, G01, O33