When Financial Sectors Become “Too Large”

At the end of July Alan Greenspan published an Op Ed arguing that tighter financial regulation and capital standards will lead to the accumulation of “idle resources that are not otherwise engaged in the production of goods and services” and are instead devoted “to fending off once-in-50 or 100-year crises” resulting in an “excess of buffers at the expense of our standards of living.”

Greenspan’s Op Ed was followed by a debate on whether capital buffers are indeed idle resources that may harm economic growth (Krugman, 2011; Cowen, 2011; Salomon, 2011). Discussion on Greenspan’s implicit assumption that larger financial sectors are always good for economic growth was more limited.

There is a well established literature showing that that financial development has positive effect on economic growth (e.g., King and Levine, 1993; Levine and Zervos, 1998; Levine, Loayza, and Beck, 2000; Beck, Levine, and Loayza, 2000; Rajan and Zingales, 1998). Although some authors have questioned the robustness of this relationship (Demetriades and Hussein, 1996; Arestis and Demetriades, 1997; Arestis et al., 2001; and Rousseau and Wachtel, 2011), most economists remain convinced that finance does have a positive effect on economic growth.

In recent work we use different types of data and econometric techniques to check whether the relationship between financial development and economic growth is non-monotone. We find strong evidence in that direction. In particular, we find that the marginal effect of financial development on GDP growth becomes negative when credit to the private sector reaches 110 per cent of GDP (the results are summarized here).

Although we do not look at the channels through which a large financial sector may reduce GDP growth, we note that there is evidence that output volatility has a negative effect on growth (Ramey and Ramey, 1995) and that large financial sectors increase macroeconomic volatility (Easterly et al., 2000). It is thus possible that large financial sectors decrease growth by increasing macroeconomic volatility.

While former Chairman Greenspan implicitly assumed that stricter regulation will have a negative effect on financial intermediation and depress future GDP growth, our results suggest that there are many countries for which tighter credit standards could actually increase growth.