Too Much “Too Much Finance” to Believe?
Some of the recent “too much finance” studies arrive at estimates that indicate implausibly large negative effects for high-income countries. Thus, when the 1960-2010 equation estimated by Arcand, Berkes, and Panizza (2012) is applied to Japan, it turns out that Japan could achieve annual growth 1.6 percentage points higher if only it would reduce its ratio of private credit to GDP from 178 to 90 percent.[211] A more recent paper by several IMF staff members devises a new Financial Development Index (Sahay et al.
2015). The study then finds that at Japan's financial development (0.85) annual growth is 3 percentage points lower than it would be if the index were lower at the optimal level of 0.5 (p. 16). These estimates, especially by the IMF researchers, are too large to be credible. The latter would imply boosting annual labor productivity growth from a typical 1.7 percent per year to a remarkable 4.7 percent per year.[212] The estimates of Cecchetti and Kharroubi (2012) are less implausible in this regard. They apply private credit from banks, which stands at 105 percent of GDP for Japan (World Bank 2015b). Their optimal financial depth ratio is 94 percent. In their estimated equation, the excess finance of Japan causes a reduction in the growth rate of only 0.02 percent.[213]It seems highly likely that the reason for the much smaller impact is that Cecchetti and Kharroubi (2012) estimate their equations for only 50 countries, whereas both the Arcand, Berkes, and Panizza (2012) and Sahay et al. (2015) studies estimate equations for about 130 countries. A central proposition of this chapter is that the supposed negative quadratic term on finance is picking up the influence of lower growth at higher per capita income. In other words, the specification of the per capita income term itself
is inadequate to capture convergence fully and leaves some false attribution of convergence to financial depth.[214] It is far more likely that the single per capita income variable (log of income per capita) will be overburdened and less capable of complete explanation of convergence when a large number of much smaller and poorer economies are included in the set of countries examined.[215]
The findings in the BIS and IMF studies that too much finance reduces growth should thus be viewed with considerable caution.
(Appendix 6C replies to a comment from the authors of one of the IMF studies.) The reason is that there is an inherent bias toward a negative quadratic term in a regression that incorporates financial depth, or any other variable that tends to rise with per capita income, along with the usual convergence variable (logarithm of per capita income) in explaining growth. That the results may well be unreliable is demonstrated here by finding a statistically significant negative quadratic term in equations that “explain” growth by spurious influences: doctors per capita, R&D technicians per capita, and fixed telephone lines per capita. In some situations, finance can become excessive; the crises of Iceland and Ireland come to mind. But it is highly premature to adopt as a new stylized fact the recent studies' supposed thresholds beyond which more finance reduces growth.