Thresholds in the Finance-Growth Nexus: A Cross-Country Analysis
One sentence summary: Finance accelerates economic growth when inflation is below 8%.
The paper is available here.
Abstract
Thresholds of inflation, government size, trade openness, and per capita income for the finance-growth nexus are investigated using five-year averages of standard variables for 84 countries from 1965 to 2004. The results suggest that (i) high inflation crowds out positive effects of financial depth on long-run growth, (ii) small government sizes hurt the finance-growth nexus in low-income countries, while large government sizes hurt high-income countries, (iii) low levels of trade openness are sufficient for finance-growth nexus in high-income countries, but low-income countries need higher levels of trade openness for similar magnitudes of the finance-growth nexus, (iv) catch-up effects through the finance-growth nexus are higher for moderate per capita income levels.
Non-technical Summary
Non-technical Summary
The benefits obtained by individuals from eliminating the whole macroeconomic instability in a given economy are almost certain to be negligibly small, when compared with those that can be obtained with more growth. Therefore, even the global financial crisis that has started at the end of 2007, considered to be the biggest one since the Great Depression by most economists, should not matter from a welfare analysis point of view, and countries, especially the developing ones, should still focus on the long-run growth. In this context, the impact of financial development on the long-run growth is of particular interest: A healthy financial system not only encourages savings, but also improves the allocation of such savings to efficient investment projects; this, in turn, encourages an efficient and high level of capital formation to promote growth. However, what are the necessary economic conditions and/or environments to achieve such a healthy finance-growth nexus? Does high inflation lead financial depth to show its negative impacts on growth or does it only eliminate the positive effects? Is there any optimal level of trade openness or government size for the development of finance-growth nexus in low-income and high-income countries? Who benefits most from the catch-up (convergence) effects through the finance-growth nexus? Is the finance-growth nexus stable through time? All these questions are sought to be answered here by investigating the historical experiences of 84 countries from 1965 to 2004 and considering the nonlinearities in the finance-growth nexus through a continuous threshold analysis.
The effect of inflation on growth is found to be negative, especially in the literature on empirical growth. This is attributed to increasing uncertainties, mostly because of increasing relative price variability, increasing difficulties in planning, or increasing expectations of disinflation. This study finds that high inflation crowds out the positive effects of financial depth on long-run growth; however, the threshold inflation rate estimated by this study is about 8 percent, independent of the financial-depth measure used.
The effect of inflation on growth is found to be negative, especially in the literature on empirical growth. This is attributed to increasing uncertainties, mostly because of increasing relative price variability, increasing difficulties in planning, or increasing expectations of disinflation. This study finds that high inflation crowds out the positive effects of financial depth on long-run growth; however, the threshold inflation rate estimated by this study is about 8 percent, independent of the financial-depth measure used.
The government expenditure can promote growth through the provision of public goods, such as property rights, national defense, legal system, and police protection; however, large public expenditures would tend to crowd out potentially productive private investments. The empirical evidence is in line with this claim suggesting that the effects of government size on growth are mixed. In the context of the finance-growth nexus, this study shows that small government sizes hurt low-income countries (e.g., owing to the lack of sufficient public goods, such as infrastructure or property rights, to have an effective financial system), while large government sizes hurt high-income countries (e.g., owing to the crowding-out effect described earlier); thus, the optimal government size, on an average, is found to be between 11 and 19 percent.
Trade openness can endorse growth through providing access to large and high-income markets, together with low-cost intermediate inputs and technologies; however, it can also lead to more vulnerability through international shocks (either trade or finance). Such effects of trade openness on growth have been studied extensively. Although relatively recent works assign an important role for trade openness in economic growth, considerable skepticism does exist about this relationship. On the contrary, low-income countries need higher levels of trade openness for similar magnitudes of finance-growth nexus, because they can benefit from larger, high-technology and high-income markets only through high levels of openness.
The argument that low-income countries can grow faster than high-income countries has been studied extensively. The so-called "catch-up effect" is due to the low costs of industrialization in low-income countries through imitating already-developed technologies in high-income countries. This story can be connected to the neoclassical theory of diminishing returns to physical capital, which should cause more advanced countries to grow more slowly than the less advanced countries. However, in empirical terms, the evidence is mixed. As financial development is costly and difficult, one would expect that catch-up effects would start manifesting only after the income crosses a certain threshold value. Considering all possible income levels, this study shows that the catch-up effect, through the finance-growth nexus, does not start until a country reaches the threshold per capita income level of about $665 (in constant 1995 U.S. dollars), and that it would not work effectively until that income level reaches about $1,636 (in constant 1995 U.S. dollars).
Overall, this research paper has generalized the empirical studies on the finance-growth nexus by considering the thresholds in several explanatory variables. Following are the suggestions that emerged from this study: (i) Inflation rates above 8 percent eliminate the positive effects of financial depth on the long-run growth. (ii) Optimal government size (% GDP) for the finance-growth nexus is between 11 and 19 percent; government sizes below 11 percent hurt the low-income countries, and those above 19 percent hurt the high-income countries. (iii) Optimal trade openness for the finance-growth nexus is below about 35 percent for high-income countries, and above about 75 percent for low-income countries. (iv) The catch-up effect through finance-growth nexus starts when a country passes the threshold per capita income level of about $665; it has its highest impact when the per capita income is about $1,636; its impact decreases as the per capita income increases. (v) There is evidence to show that financial-depth effects on growth decrease through time. (vi) The thresholds in the initial per capita income seem to be more important than other thresholds.