In line with Thorsten Beck’s post, I would like to emphasize the issue related to the measurement of financial deepening.
The crisis has seriously altered the mindset on the supposed positive impact of finance on growth. The crisis also called into question the commonly accepted measures to assess the growth of the financial sector. In the finance-growth literature, the size of the financial sector is traditionally proxied by its outputs. The preferred measures are: the ratio of the credits to the private sector to GDP, the ratio of liquid liabilities to GDP and the ratio of commercial banks credits to the sum of commercial and central banks credits. All these proxies implicitly assume quality is increasing with quantity.
Several attempts have been made recently to consider better proxies of financial deepening. Beck et al. (2009) distinguish bank lending to firms and to households, and show that only the former spurs economic growth. Hasan et al. (2009) focus on the quality of financial services thanks to a sophisticated measure of bank efficiency and show that it has a positive impact on regional growth, while credit volume has not.
I claim that an additional way to tackle this issue is to gauge the size of the financial sector based on its inputs – rather than its outputs. In a recent paper (Capelle-Blancard and Labonne, 2011), we reexamine empirically the finance/growth nexus by using two original measures of financial deepening related to the number of employees in the financial sector.
In its column, Thorsten Beck considers that such an approach is the expression of the financial center view, by opposition to the literature on the relationship between financial intermediation and growth. This distinction is appealing. Still, considering data on employment (or wages or value added) can be useful to assess the impact of financial development on growth. Using the number of employees to assess the size of an industry is quite usual in the economic literature (for instance, it is common to use the number of engineers to gauge the pace of innovation), but strangely not in financial economics.
Precisely, we consider two variables: i) the number of employees in the financial sector divided by the total workforce and ii) the ratio private credit divided by the number of employees in the financial sector. Our aim is to tackle the two following problems.
- Excessive growth of credit. An increase of credit volume – the most common proxy for financial deepening – does not mean that the financial sector fulfills its functions better (the same is true also for market capitalization). Sometimes, this is even just the opposite. As stated by Rousseau & Wachtel (2011), an excessive growth of credit may undermine the financial system and hurt economic growth. Further, Arcand et al. (2011) have recently suggested that finance has a negative impact on growth when private credit is above a threshold estimated as 110% of GDP.
- Misallocation of talents. Since Baumol (1990) and Murphy et al. (1991), the allocation of talent is understood as an important determinant of growth. Recently, Philippon (2009) and Bolton & Scheinkman (2011) have examined theoretically the equilibrium size of the financial sector, while Goldin & Katz (2008) or Philippon & Reshef (2008) provide empirical evidence that the growth of the financial industry has attracted too many talents, to the detriment of others industries. During the crisis, such concern was vividly expressed, in particular by Lord Turner, the chairman of the UK’s Financial Services Authority, who declared in 2009 that the financial industry had grown “beyond a socially reasonable size” (see Esther Duflo’s post).
The share of employees working in banking and finance is a direct measure of the potential misallocation of talents. The ratio private credit to number of employees in the financial sector can alleviate the problem raised by an excessive growth of credit and unproductive financial deepening, although it cannot fully solve it. Usually, an increase of an output/input ratio is interpreted as an improvement of the economic process. But it is unclear whether an increase of private credit relative to the number of employees captures a higher ability of the financial sector to convert efficiently inputs into outputs (more research is needed to assess how the financial sector accomplishes its tasks).
In our paper, we consider difference and system estimators for a panel of 24 OECD countries over the period 1970-2008 (our methodology is directly comparable with the bulk of evidence on the finance-growth nexus). Overall, we confirm the absence of a positive relationship between financial deepening and economic growth for OECD countries over the last forty years.
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