Too Much Finance

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Too Much Finance? Jean Louis Arcand The Graduate Institute

Enrico Berkes IMF

Ugo Panizza UNCTAD

March 2011∗ Preliminary: Comments welcome

Abstract This paper examines whether there is a threshold above which financial development no longer has a positive effect on economic growth. We develop a simple model in which the expectation of a bailout may lead to a financial sector which is too large with respect to the social optimum. We then use different empirical approaches to show that there can indeed be “too much” finance. In particular, our results suggest that finance starts having a negative effect on output growth when credit to the private sector reaches 110 percent of GDP. We conclude by showing that the size of the financial sector was a significant amplifying factor in the global crisis that followed the collapse of Lehman Brothers in September 2008.

..we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity. James Tobin (1984)

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Introduction

This paper provides a fresh look at the relationship between financial development and economic growth. It reproduces the standard result that, at intermediate levels of financial development, there is a positive relationship between the size of the financial system and economic growth, but it also shows that, at high levels of financial development, more finance is associated with less growth. This non-monotone relationship between economic growth Email: jean-louis.arcand@graduateinstitute.ch, eberkes@imf.org, ugo.panizza@unctad.org. We would like to thank Jörg Mayer for helpful comments. The views expressed in this paper are the authors’ only and need not reflect, and should not be represented as, the views of any of the institutions that the authors are affiliated with. ∗

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