finance-growth nexus

The field of economic growth is a puzzling research journey that flourished over the last century. One of the pioneers of economic growth, Joseph Alois Schumpeter theorized throughout his career the dynamics of economic growth with a micro-foundational focus. Accordingly, long-run economic growth is a process of deliberate economic investments by profit-seeking firms into innovation, a knowledge-creation process that improves the quality of production technologies available in the economy. Thus, technological change continuously offsets the dampening effects of diminishing returns. New inventions replace old technologies or products by making them obsolete.

With the specification of credit-based entrepreneurial activities, Schumpeter's earlier work on economic development inspired other scholars regarding the interaction of the role of finance in the growth process, also known as the finance-growth nexus. Schumpeter (1912) argued that banks lend as if they are financing the innovating firms in the economy. Intuitively, the argument appears intriguing. Yet, specifying the role of banks in an innovation economy theoretically is a convoluted journey. In addition to Schumpeter, other pioneering authors who emphasized the importance of the relationship between finance and growth include Bagehot (1873), Gurley (1955), Goldsmith (1969), and McKinnon(1973). Most of the research done in this field recently has been empirical to show that there is indeed a strong connection between the financial sector and the growth trajectory of an economy. Aghion et al. (2018) survey some of those major developments and empirical results in the finance-growth nexus.

Levine and King (1993) and Rajan and Zingales (1998) are considered as the seminal works in the empirical field of finance-growth nexus. Note that in most of the following papers, financial development is usually measured by the credit to GDP ratio. Both Levine and King (1993) and Rajan and Zingales (1998) are motivated to test the hypothesis of Schumpeter (1912) that the development of the financial sector in an economy contributes positively to the economic growth rate. To analyze this hypothesis, Rajan and Zingales (1998) construct a novel empirical methodology and show that cost of external finance to firms declines as financial markets develop, which is one of the main factors fostering the economic growth rate.

Moreover, evidence indicates that the mobilization of savings through financial intermediaries is a major contributor to economic growth (Levine, 2005). More recent evidence exhibit that long-term innovation investment behavior tends to be countercyclical, meaning that the intensity of innovation is higher during a recessionary economic period (Aghion et al., 2010, 2012). The lower return to productive activities during recessions attracts higher productivity-enhancing investments because the opportunity cost of these investments is lower. Through this process, a recession may have a productivity-enhancing impact during recessionary periods on a long-run growth trajectory. Nevertheless, credit market imperfections may prevent efficient entrants and incumbents from reorganizing or innovating during recessions. This holds because during recessionary periods firms' profits are lower, which decreases the ability to borrow external funds to finance R&D investments. As a result, the innovation investment behavior of firms becomes pro-cyclical when firms face stringent credit constraints. Aghion et al. (2010) suggest that countercyclical fiscal and monetary policies will enhance the economic growth rate in financially constrained countries and sectors by reducing the adverse effects of recessionary periods on productivity-enhancing investments. Therefore, financial development and tightness of credit constraints affect the effectiveness of fiscal and monetary stabilization policies.

The convergence debate is one of the major streams within economic growth literature, that mostly started with the seminal contribution of Solow (1956). The convergence debate implies that poor countries have a higher propensity to grow faster than the rich when they are further below the steady-state levels. So economies with lower levels of per capita income or product should eventually catch up to the developed economies in the long run. Even after fifty years of research, certain systematic differences in cross-country convergence and divergence patterns of economic growth still remain somewhat unaccounted for (Johnson and Papageorgiou, 2020). Although there is a multitude of other reasons contributing to the divergence of economic growth rates across countries, evidence indicates that financial development is one of the major forces that contribute to cross-country convergence and divergence. Aghion et al. (2005) demonstrate the intensity of credit constraints as a potential source of cross-country divergence. According to their findings, financial development exerts a positive impact on cross-country convergence towards the steady-state economic growth rate. Countries below the necessary level of financial development will exhibit divergence from the steady-state growth rate. This property arises because the frequency of innovation is hampered through financial constraints in countries with underdeveloped financial systems.

Figure 1: The cyclicality of innovation investment and credit constraints, Source: Aghion et al. (2012)

Using a French firm-level panel data between 1994 and 2004, Aghion et al. (2012) measure credit constraints. They reveal that macroeconomic recessions are mitigated when financial markets are perfect because firms are engaged in more long-run innovation investments, which somewhat counterbalances declining economic performance. In countries with lower credit to GDP ratios, growth-enhancing investments (proxied by structural investments) tend to be less countercyclical. Potentially, a more countercyclical monetary and fiscal policy should be able to address at least some of the frictions created by financial market imperfections.

On the other hand, recent evidence suggests a more nuanced relationship between finance and growth. Specifically, financial development exerts an inverted u-shaped (non-linear) effect on economic growth. At the low (high) levels of financial development, improving financial systems is positively (negatively) related to economic growth (Cecchetti and Kharroubi, 2012; Gambacorta et al. 2014; and Arcand et al. 2015). From more recent literature, Unger (2018) analyzes this negative relation between bank credit and economic growth and reveals that the main reason for this negative relation found in the literature is because most bank credit is extended to households, not to non-financial corporations, or innovating firms. Therefore, bank credit does not have to be replaced by market financing, such as trade credit that is extended between trade partners.

From the above-mentioned empirical findings, one can deduce the following stylized facts

Stylized Fact 1: Better functioning financial markets support the economic growth trajectory

Stylized Fact 2: Innovation investments are countercyclical under complete financial markets but become procyclical under imperfect financial markets

Stylized Fact 3: Credit market imperfections are a source of cross-country divergence

Stylized Fact 4: Countercyclical macroeconomic policy partially mitigates financial market imperfections

In the next blog post, I will talk about the role of firm size in the finance-growth nexus. Firstly, talking about the empirical findings and then bringing in theoretical results from my own research.

References:

1. Aghion, P., G.-M. Angeletos, A. Banerjee, and K. Manova (2010). Volatility and growth: Credit constraints and the composition of investment. Journal of Monetary Economics 57(3), 246–265

2. Aghion, P., P. Askenazy, N. Berman, G. Cette, and L. Eymard (2012). Credit constraints and the cyclicality of r&d investment: Evidence from France. Journal of the European Economic Association 10(5), 1001–1024.

3. Aghion, P., P. Howitt, and R. Levine (2018). Financial development and innovation-led growth. In Handbook of finance and development. Edward Elgar Publishing

4. Aghion, P., P. Howitt, and D. Mayer-Foulkes (2005). The effect of financial development on convergence: Theory and evidence. The Quarterly Journal of Economics 120(1), 173–222.

5. Arcand, J. L., E. Berkes, and U. Panizza (2015). Too much finance? Journal of Economic Growth 20(2), 105–148

6. Bagehot, W. (1873). Lombard Street: A description of the money market. HS King&Company.

7. Cecchetti, S. G. and E. Kharroubi (2012). Reassessing the impact of finance on growth. BIS working paper No 381

8. Gambacorta, L., J. Yang, and K. Tsatsaronis (2014). Financial structure and growth1. International banking and financial market developments 3, 21

9. Goldsmith, R. W. (1969). Financial structure and development. Technical report.

10. Gurley, J. G. and E. S. Shaw (1955). Financial aspects of economic development. The American Economic Review 45(4), 515–538.

11. Johnson, P. and C. Papageorgiou (2020). What remains of cross-country convergence? Journal of Economic Literature 58(1), 129–75

12. King, R. G. and R. Levine (1993). Finance and growth: Schumpeter might be right. The quarterly journal of economics 108(3), 717–737.

13. Levine, R. (2005). Finance and growth: theory and evidence. Handbook of economic growth 1, 865–934.

14. McKinnon, R. I. (1973). Money and capital in economic development.

15. Rajan, R. G. and L. Zingales (1998). Financial dependence and growth. The American Economic Review 88(3), 559.

16. Schumpeter, J. A. (1912). Theorie der wirtschaftlichen Entwicklung. Leipzig: Dunker& humblot. The theory of economic development

17. Solow, R. M. (1956). A contribution to the theory of economic growth. The quarterly journal of economics 70(1), 65–94.

18. Unger, R. (2018). Revisiting the finance and growth nexus: A deeper look at sectors and instruments.