Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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.

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