An interesting paper by William Cline of PIIE. Lately, there has been some research which shows that too much finance leads to lower growth. The author critques such research.
He says much of this has been shown using a kind of econometric trick. What people have done is added a quadratic term (of say financial deepening) in the regression equation. This shows a negative coefficient leading people to make their claims that after such and such ratio/percentage (of say bank assets to GDP), finance leads to lower growth.
Fair enough. The author says one could actually do the same for doctors, telephones, R&D and so on. His analysis shows the coefficient is negative here as well. So, after so many doctors, so many telephones etc growth becomes lower. Does this sound plausible?
This Policy Brief shows that these recent fi ndings warrant considerable caution, however, because the negative quadratic term may be an artifact of spurious attribution of causality. I fi rst show that correlation without causation could similarly lead to the conclusion that too many doctors spoil growth (for example). I then demonstrate algebraically that if the variable of interest, be it fi nancial depth, doctors, or any other good or service that rises along with per capita income, is incorporated in a quadratic form into a regression of growth on per capita income, there will be a necessary but spurious fi nding that above a certain point more of the good or service in question causes growth to decline.
Fascinating. This quadratic term is an old idea (or a trick now) in econometrics and amazing to see how it has been used this time. It usually shows a negative term just to limit the same excesses (have limited understanding of this though).
Though, the author misses the main point. People used same tricks before the crisis as well. All kinds of fancy regressions were invented to show that only finance matters for growth. This was used to push policy agenda. So all kinds of financial indicators (bank assets, equity markets, bank accounts etc) were used to show how they lead to GDP growth. This was a phase where GDP growth was rising generally and by fitting such regressions, positive relationships were not difficult to find. So the mantra was simple. Just let financial sector grow. And hence, finance professors became the new dons and got huge fame. They were appointed to all kinds of committees to drive financial sector of respective countries. Same with the finance sector.
Post-crisis, we are now questioning these findings and arguing the opposite. After all, we have to show that the discipline is responsible and knows things. Nothing could be further from truth. It is even more bizarre that the professors who argued for finance earlier have only seen their fame grow!!
Another point is it is not right to compare finance with medicine/telephones/R&D etc. Finance interacts with the economy in many more ways than all these other factors. Too many doctors, telephones etc hardly impact the economy adversely but finance surely does. This is nothing new. For ages, speculations and manias in finance have impacted economies.
For any development, one needs several factors and finance is just one of them. We had overdone the analysis earlier and are perhaps overdoing it now.