In the two decades leading to the Great Recession, academics had mostly converged on Schumpeter’s view that well-developed financial systems play a crucial role in stimulating economic growth. A host of academic papers had concluded that deeper domestic financial markets improve economic efficiency, lead to a better allocation of productive capital, and increase long-term economic growth (see Levine 2005 for a recent review). In fact, the body of empirical evidence linking causally and positively the depth of financial markets to growth was growing so rapidly that in 2003, in a discussion of a survey on the subject, one author was prompted to conclude that “[…] In 1993 many people doubted that there was a relation between finance and growth; now very few do” (Zingales 2003).
Others were cautioning against excessive optimism, arguing that more dynamic financial industries and more integrated financial markets are associated with more frequent financial shocks and higher macroeconomic risk. For example, there has been a strong perception that foreign capital increases volatility both in the financial markets and in the real economy (Stiglitz 2000). Needless to say, the financial crisis of 2007–09 and the global collapse in economic activity it caused reinforced this view.
Are these two views compatible? In this column, we will argue that the answer is yes; that there is a tradeoff between growth and risk and that vibrant financial markets may tend to exacerbate this tradeoff.1 In this context, the goal of financial regulation and macroprudential policies must be to reduce systemic risk without eliminating the financial sector’s contribution to long-term economic growth. This requires an understanding of which features of the financial system are conducive to economic growth and which ones increase its fragility and the probability of a costly financial crisis.
Financial markets and economic growth
Early evidence on the effect of finance on growth suggested that a country which in 1960 increased the size of its financial sector (measured as the ratio of liquid liabilities to GDP) from the mean of the slowest-growing to the mean of the fastest-growing quartile of countries would have increased its average growth rate between 1960 and 1990 by almost 1% per year (King and Levine 1993). Financial market liberalisation – in particular, equity market liberalisation – has also been found to raise long-term growth by about 1% per year (Bekaert et al 2005).
In general, financial markets provide valuable services, like channelling resources from people with money and no ideas to people with ideas and no money, screening out unproductive projects, and actively monitoring and providing value-enhancing services to productive projects. As a result, deep and efficient financial markets improve economic performance both through raising the level of growth (Rajan and Zingales 1998) and through a more efficient allocation of productive capital (Wurgler 2000), ultimately generating benefits for the society as a whole. Importantly, evidence from emerging markets suggests that for these effects to be realised, a country needs to have a reasonably large financial sector, otherwise the contribution of finance to economic growth can be limited (Demirgüç-Kunt et al 2008). The positive effects of financial openness also accumulate only when the domestic financial system is relatively developed.
That larger financial markets are associated with higher economic efficiency is not a feature of emerging markets only, however (Hartmann et al 2007). Consider the longstanding point in academic and policy discussion on the differences in average GDP growth between the US and continental Europe in the 1990s. It has been suggested that deeper financial markets across the Atlantic are to a large extent responsible for the higher labour-productivity growth and the higher rate of new business creation in the US.
The divide is especially visible when it comes to the financing of innovative ideas and the commercialisation of science. The much larger US venture capital industry has been credited over the years with assisting the emergence of whole new industries and of such innovative corporate giants like Microsoft, Cisco, and Google, for example. Strikingly, out of the 500 largest companies in the world, there are 26 US ones born after 1975, compared with only three European ones (Philippon and Veron 2008). Empirical research has found that the involvement of venture capitalists with micro projects does result in more innovation through higher survival rates of highly innovative but highly risky projects. For example, while the ratio of venture capital to industrial R&D averaged less than 3% between 1983 and 1992, venture capital accounted for 8% of industrial innovation over that period (Kortum and Lerner 2000). More recent investigations with data up to 2008 have broadly confirmed this result (Hirukawa and Ueda 2008). It has also been argued that a substantial portion of the variation in patenting rates across European countries can be explained by differences in the size and efficiency of their venture capital industries (Popov and Roosenboom 2009).
Financial markets and macroeconomic risk
In order to be able to claim that finance has a Pareto-improving effect, one also needs to know its effect on the variability of the growth process. Academics used to worry much less about the contribution of finance to macroeconomic volatility, because it is commonly believed that the welfare benefits of removing all of the business-cycle volatility are small, and so, by extension, the welfare costs of higher volatility are negligible (Lucas 1987). Past studies that found evidence of a positive contribution of finance to aggregate volatility usually included the caveat that the negative effect on welfare from higher volatility is most probably fully outweighed by its contribution to growth (Kose et al 2003 and Levchenko et al 2009).
The problem with this reasoning is that a measure of macroeconomic volatility does a poor job in capturing the incidence of large, abrupt, and rare crises. For example, the economies of Argentina and Panama have been similar in terms of aggregate output growth volatility in the past two decades. However, unlike Panama, Argentina experienced one large crisis during this period, resulting in a 71% output loss over four years (computed as the cumulative difference between actual and trend real GDP and expressed as a percentage of trend real GDP) (Laeven and Valencia 2010). Such an economic disaster can have major implications for welfare. Some academics have recently estimated within a class of models that replicate how asset markets price consumption uncertainty that individuals would be willing to pay very high premia (of the order of 20% of GDP each year) in exchange for eliminating all chances for large macroeconomic contractions (Barro 2006).
Therefore, it is essential to assess the contribution of finance not just to business-cycle volatility, but also to the probability of rare economic catastrophes. Is there such a contribution? An influential study by Kaminsky and Reinhart (1999) provided early evidence to that end by demonstrating that crises are usually preceded by rapid growth in financial aggregates. Various studies using similar tools from the “Early Warning Systems” toolkit have documented that the recent financial crisis was also preceded by out-of-trend growth in various financial aggregates (Alessi and Detken 2009). Popov (2011) recently estimated the effect of finance on growth and on the probability of rare disasters in a unified empirical framework. The resulting evidence suggests that financial openness, broadly speaking, increases simultaneously level growth as well as the left-skewness of the distribution of output growth. This implies that both the finance-and-growth literature and the literature that has found a positive effect of finance on crises may be right – growth may on average have picked up thanks to deep and integrated financial markets, but the probability of large economic downturns has increased too.
The recent crisis also serves as a stark reminder of the contribution of the banking sector to systemic risk. While banks provide an important support to a country’s economy by transforming savings into productive investment, the maturity transformation each individual bank performs makes it inherently fragile, the (often opaque) interconnectedness of individual banks makes the whole banking sector prone to runs and panic, and the too-big-to-fail issue tends to exacerbate banks’ moral hazard. In that vein, it is useful to compare the liquidity spirals, asset fire sales, interbank market freezes, and general deleveraging that we witnessed in 2007-08 with the much more orderly burst of the dot-com bubble. One simple reason for this difference is that the credit boom of the 2000s was driven by debt finance, while the dot-com bubble was mostly driven by an expansion in equity ownership, and equity is not held in levered portfolios.
What to do? The role of financial regulation and macroprudential policies
The welfare implications of the combined phenomena of higher growth and risk are still to be understood. Schumpeter’s view was that cycles are efficient. Because productive ideas do not arrive at a constant rate, economic growth tends to be associated with a boom phase, followed by a recession that ensures that unproductive projects are cleansed from the economy. In contrast, Minsky (1986) – and also Kindleberger (1978) – contended that finance tends to cause an inefficient boom-bust cycle. Good times give rise to speculative investor euphoria and excessive debt and leverage which ultimately leads to a costly financial crisis.
In view of these arguments, the policymaker’s objective becomes one of distinguishing ‘good’ from ‘bad’ booms, and of reducing the contribution of financial markets to tail risk without eliminating their contribution to growth. Ideally, the macroprudential tools employed would be such as to allow policymakers to forcefully lean against the wind during costly booms driven by excessive debt and characterised by no fundamental contribution to long-term growth (more like the mid-2000s) while reacting more cautiously during low-cost booms driven by equity finance and characterised by a wave of new technologies (more like the dot-com bubble). Similarly, the regulatory response should be targeted to the sources of market failures and externalities in the financial sector and preserve its positive contribution to growth.
Author's note: The views expressed are our own and not necessarily those of the ECB.
Alessi, L, and C Detken (2009), "Real time early warning indicators for costly asset price boom/bust cycles - a role for global liquidity". ECB Working Paper Series 1039.
Barro, R (2006), “Rare disasters and asset markets in the twentieth century.” Quarterly Journal of Economics 121: 823-66.
Bekaert, G, Harvey, C, and C Lundblad (2005), “Does financial liberalization spur growth?” Journal of Financial Economics 77, 3-55.
Davies, H, and D Green (2010), Banking on the future: The fall and rise of central banking, Princeton, NJ: Princeton University Press pp. 281-82.
Demirgüç-Kunt, A, Beck, T, and P Honohan (2008), “Finance for All? Policies and Pitfalls in Expanding Access.” World Bank: Washington, DC.
Hartmann, P, F Heider, M Lo Duca, and E Pappaioannou (2007), "The role of financial markets and innovation for productivity and growth in Europe". ECB Occasional Paper 72.
Hirukawa, M, and M Ueda (2008), “Venture capital and industrial ‘innovation’”. CEPR Discussion paper 7089.
Kaminsky, G, and K Reinhart (1999), "The twin crises: The causes of banking and balance-of-payments problems". American Economic Review 89: 473-500.
Kindleberger, C (1978), Manias, panics and crashes: a history of financial crises. Palgrave Macmillan.
King, R, and R Levine (1993), “Finance and growth: Schumpeter might be right”. Quarterly Journal of Economics 108: 717-37.
Kortum, S, and J Lerner (2000), “Assessing the contribution of venture capital to innovation.” RAND Journal of Economics 31, 674-692.
Kose, A, E Prasad, K Rogoff, and S-J Wei (2003), “Effects of financial globalization on developing countries: Some empirical evidence”. International Monetary Fund Occasional Paper 220.
Laeven, L, and F Valencia (2010), “Resolution of banking crises: The good, the bad, and the ugly”. IMF working paper 10/146
Levchenko, A, R Ranciere, and M Thoenig (2009), “Growth and risk at the industry level: The real effects of financial liberalization”. Journal of Development Economics 89, 210-22.
Levine, R (2005), “Finance and growth: Theory, evidence, and mechanisms”. in The Handbook of Economic Growth, by,Aghion, P. and S. Durlauf (eds), Amsterdam: North-Holland.
Lucas, R (1987), Models of Business Cycles. New York: Basil Blackwell.
Minsky, H (1986), Stabilizing an unstable economy. New Haven: Yale University Press. See also Kindleberger, C P (1978), Manias, panics and crashes: a history of financial crises. Palgrave Macmillan.
Philippon, T, and N Veron (2008), “Financing Europe's fast movers.” Bruegel Policy brief 2008/01
Popov, A (2011), “Output growth and fluctuations: The role of financial openness”. ECB Working paper 1368.
Popov, A, and P Roosenboom (2009), “On the real effects of private equity investment: Evidence from new business creation”. ECB Working paper 1063.
Rajan, R, and L Zingales (1998). “Financial dependence and growth”. American Economic Review 88: 559-86. See also Alessi and Detken (2009), “Real time early warning indicators for costly asset price boom/bust cycles - a role for global liquidity”. ECB Working Paper Series 1039 and Hartmann, P, F Heider, M Lo Duca, and E Pappaioannou (2007), “The role of financial markets and innovation for productivity and growth in Europe”. ECB Occasional Paper 72.
Stiglitz, J (2000), “Capital market liberalization, economic growth and instability”. World Development 28, 1075-1086.
Wurgler, J (2000), “Financial markets and the allocation of capital”. Journal of Financial Economics 58, 187-214.
Zingales, L (2003). Commentary on “More on finance and growth: More finance, more growth?” The Federal Reserve Bank of St. Louis Review 85, 47-52.
1 This tradeoff is of all times. See, for example, Trichet’s account of the Banque de France’s gold lending to the Bank of England in the 1820s when London was going through various booms and busts but was also in the throes of an industrial revolution. See Davies and Green (2010).