Finance and economic growth

It is by now widely acknowledged that finance matters for economic growth and that the financial system may have an important impact on the speed and the stability of economic growth. Following "real analysis" (Schumpeter, 1954, p. 277) and hence the "classical dichotomy" between the "real" and the "monetary" spheres of the economy, classical, neoclassical and new classical mainstream economics consider that the growth of economic activity is determined by "real" forces only. However, there have always been dissenting views in the history of economic thought relying on "monetary analysis" (ibid., p. 278), in which monetary and financial factors matter for the determination of output and economic growth beyond the short run. Outstanding examples are the con- tributions by Marx (1894) on the role of credit for economic expansion and instability, by Schumpeter (1912) on the generation of credit "out of nothing" as a precondition for investment finance by innovative entrepreneurs triggering an economic upswing, and Keynes's (1933 [1987]) plea for a "monetary theory of production", as well as his clarifi- cations of the role of finance generated and provided by banks for economic expansion (Keynes, 1973).

The dominating contemporary orthodox views on finance and economic growth are based on the supply-driven new growth theory and the asymmetric information approach to the financial sector (Pagano, 1993). These approaches assume exogenous money under the control of the central bank. Commercial banks and other financial institutions act merely as intermediaries between the pool of saving and investment. Saving thus deter- mines investment and hence economic growth. Because of asymmetric information, an appropriate financial system promotes economic growth through the following channels (Levine, 2005):

(1) it generates information about profitable investment projects and thus improves the allocation of capital;

(2) it monitors the use of funds in the investment process, thus improving information and reducing moral hazard;

(3) it improves the trading, diversification and thus the management of risk;

(4) it mobilizes and pools saving; and

(5) it reduces transaction and information costs for the exchange of goods and services.

Focusing on indicators like bank deposits-GDP, credit-GDP, stock market capitaliza- tion-GDP and stock market turnover ratios, abundant empirical research has been produced with no clear-cut findings regarding the superiority of bank-based over capital- market-based financial systems, or vice versa. The general consensus has rather been that more developed financial systems, both with respect to banks and capital markets, are conducive to economic growth (Levine, 2005). However, recent empirical studies have questioned the causality and have also suggested that the positive relationship between finance and economic growth has weakened over time and may have even been reversed (Ang, 2008; Cecchetti and Kharroubi, 2012; Sawyer, 2014).

Modern heterodox views on the relationship between finance and economic growth, and the post-Keynesian approaches in particular, are based on demand-driven growth models (Hein, 2014), in which money, credit and finance are endogenously generated through the interaction of the central bank with the financial and the non-financial sectors of the economy. The banking sector plays a particular role in generating credit money and creat- ing "initial finance" for investment, which then generates income and saving. The latter is then available for "final finance" or long-term funding of investment projects. A well- functioning banking sector, consisting of a central bank and commercial banks, is required to get the investment and economic growth processes started by providing required liquidity (Bossone, 2001). The role of financial markets is then to allocate accumulated savings generated by investment. The importance of financial markets will increase when savings, and thus financial wealth, rise (with no equivalent rise in the demand for holding liquidity generated by central banks). A combination of the liberalization of national and international financial markets, the introduction of new financial instruments, changes in corporate governance, and so on, may lead to a dysfunctional increase in finance, which increases instability and hinders investment and economic growth, as has been analysed in the literature on "financialization" and "finance-dominated capitalism" (Hein, 2012; Palley, 2013). In this perspective, the dominance of finance contributes to redistribution at the expense of (low) labour incomes, thus dampening income-financed consumption demand. It discourages investment in real capital stock and thus in long-term development of the firm by warping managers' incentives in favour of short-term profits generated by financial investment. This leaves debt-financed household demand for consumption or debt-financed external demand improving net exports as the only drivers of economic growth, carrying with them the seeds of instability and crisis through over-indebtedness of private households and the external sector.

See also:

Asymmetric information; Classical dichotomy; Financial instability; Financialization; Keynes as monetary theorist; Marx, Karl; Monetary circuit; Money and credit; Money creation and economic growth.