Beware the Credit/GDP ratio as a measure of financial development

Thorsten Beck of Cass Business School has a piece on the topic. He paraphrases the Churchill quote on democracy:

An extensive empirical literature has shown a positive relationship between financial development and economic growth, where the former is often captured by total credit outstanding to the private sector divided by GDP (private credit to GDP). More recently, however, several studies have focused on the non-linearity in the relationship between both variables and even a possible negative relationship between them at very high levels of private credit to GDP (Arcand et al. 2011, Ceccetti and Kharroubi 2015). While not arguing against these findings, this column urges caution in their interpretation


To paraphrase Winston Churchill, private credit-to-GDP is the worst indicator to measure financial development, except for all others that are available. When interpreting regression results using this indicator, utmost caution has to be applied to distinguish the efficiency of the intermediation process from other phenomena represented by this indicator. Yes, there can be too much finance, as many countries have found out the hard way in recent crises, but this is not the same as saying that financial systems can become too developed or too efficient.  While the latter can be true, using aggregate indicators, such as private credit-to-GDP, will not serve to test this hypothesis.


This is a problem with much of economics. How to measure any economic phenomenon? There are both strengths and limitations with such measures to track economic/financial progress..



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