An alternate approach in exploring the causal link between financial development and economic growth—Evidence from advanced economies

• Author: M Dharani,Vighneswara Swamy
• Date: 01 January 2018
• Published date: 01 January 2018
• DOI: http://doi.org/10.1002/ijfe.1604

RESEARCH ARTICLE

An alternate approach in exploring the causal link between

financial development and economic growth—Evidence

from advanced economies

Vighneswara Swamy | M Dharani

IBS Hyderabad, Hyderabad, India

Correspondence

Vighneswara Swamy, IBS Hyderabad,

Hyderabad, India.

Email: vswamypm@gmail.com; vighnesh.

ibs@gmail.com

JEL Classification: E44; O16; O47

Abstract

This study explores the causal link between financial development and eco-

nomic growth in advanced economies as these countries experience signifi-

cantly higher levels of financial development. Using a fully balanced panel of

24 economies from 1983 to 2013, the study shows that when imposing a linear

relationship, the financial development and economic growth are negatively

associated in the long run. The panel granger causality tests establish the bidi-

rectional causality between the financial development variables with growth.

Employing an alternate approach of moderated mediation effect framework,

we notice that the association of financial development with economic growth

is moderated by the negative impacts of inflation, interest rate, and population

dependency; and the positive mediation effect of trade openness. The policy

implication is that there is a need to rein in inflation and real interest rates

and enhance trade openness to optimize the benefits of growing financial devel-

opment on economic growth.

KEYWORDS

dynamic panel threshold, economic growth, financial development, nonmonotonicity, panel data

estimation

1|INTRODUCTION

A substantial strand of literature on finance–growth

nexus has provided compelling evidence that financial

development exerts a significantly positive effect on eco-

nomic growth. On the other hand, a new wave of litera-

ture shows that countries with high levels of financial

development tend to grow slowly. This has been an

intriguing question being investigated by few researchers

in recent times. Presently, as the financial development

indicators in advanced economies around the world are

rising at startlingly high levels,

1

there is an emergent need

being felt among the policymakers, central banks, and

international policy organizations to understand what is

the causal link between financial development on

economic growth. This paper seeks to investigate the pres-

ence of causal links in explaining the finance–growth

nexus.

The recent global financial crisis has compelled a thor-

ough reassessment of the role and benefits of financial

development and innovation, particularly in the context

of the explosion of complex instruments. Given the back-

drop of financial crisis, the sophisticated modern finance

has amplified the severity and frequency of crises while

providing little benefit to the broader economy. However,

from a societal perspective, it has brought limited gains,

but many costs. Financial innovation, in this view, has

indeed favoured the few handsomely but hurt many. Is

there an evidence that financial innovation has made

our lives measurably and unambiguously better (Rodrik,

Received: 28 September 2017 Accepted: 13 December 2017

DOI: 10.1002/ijfe.1604

Int J Fin Econ. 2018;23:55–76. Copyright © 2018 John Wiley & Sons, Ltd.wileyonlinelibrary.com/journal/ijfe 55

2008)? And hence, Wolf (2009) argued that there is some-

thing wrong with a situation in which, “instead of being a

servant, finance had become the economy's master.”

Many advanced economies despite having high levels of

financial development continue to face the growing prob-

lem of stark income inequality as well.

The relationship between financial development and

economic growth is vital and intriguing at the same time.

One strand of literature supports the notion that finance is

an engine of growth (Gurley & Shaw, 1955; King &

Levine, 1993; Levine, 2005; McKinnon, 1973; Shaw,

1973). Though financial development plays a significant

role in promoting economic development (Levine, 2005),

there are also skeptics who question the robustness of

the finance–growth nexus and argue that the role of

financial development is overemphasized (Rodrik &

Subramanian, 2009; Panizza, 2012). This strand of the lit-

erature argues that economic growth drives the demand

for financial services rather than the other way round. It

is argued that financial development occurs endogenously

as the economy reaches a critical threshold of economic

development (Deidda, 2006).

In the backdrop of the ongoing debate on the finance–

growth nexus, we seek to contribute to the literature from

an empirical perspective in the following ways. We

explore the causal link between financial development

and economic growth and especially consider the

advanced economies in providing a robust evidence. We

overcome three notable inadequacies in the empirical lit-

erature on the finance–growth nexus. First, we focus

exclusively on the advanced economies in view of their

relatively high levels of financial development. Second,

we do not find studies emphasizing the need for establish-

ing the presence of a causal link going from financial

development to growth. Third, there is a need to expand

the horizon of the data sample, as averaging across only

developing countries alone would make such inferences

difficult. Fourth, we allow for a very flexible approach to

account for unobserved heterogeneity (and thus

endogeneity) in our model, which could arise from the

omitted variables and/or global shocks that differ in their

impact across countries. Fifth, we employ the moderated

mediation effects framework to explain the effects of infla-

tion, interest rate, trade openness, and population depen-

dency on the finance–growth relationship.

This exploratory research seeks to know: (a) Is there a

declining negative relationship between financial devel-

opment and growth and (b) is there a mediated modera-

tion effect in explaining causal link going from financial

development to economic growth. This paper makes a dis-

crete contribution to the debate by offering new empirical

evidence based on a sizeable dataset, well beyond the

selective anecdotal evidence. We believe that our results

have potentially important implications for financial reg-

ulation. The originality of this analysis arises, as it over-

comes the issues related to data adequacy, coverage of

countries, heterogeneity, endogeneity, and nonlinearities.

We analyse the empirics of the finance–growth nexus

within a standard neoclassical growth model. This paper

contributes to the current strand of literature by extending

the horizon of analysis to a large data set of advanced

economies and make the study inclusive of economic,

political, and regional diversities.

The paper is organized as follows. In Section 2, we

review the literature on financial development–economic

growth nexus. Section 3 presents a description of our data

set, measures of financial development, and other vari-

ables. Section 4 describes our estimation approach involv-

ing panel least squares regressions, panel Granger

causality tests, and moderated mediation effect frame-

work. In Section 5, we provide a detailed discussion on

the results. Section 6 concludes.

2|REVIEW OF LITERATURE

Beginning with the work of Schumpeter and Opie (1934),

highlighting the role of financial institutions in funding

productive investments, and encouraging innovation, to

the crosscountry analysis of King and Levine (1993), sev-

eral econometric studies based on linear methods have

provided empirical support for the leading view that

finance promotes growth. Patrick (1966) develops the

ideas of “supply‐leading”and “demand‐following”

aspects of financial development. On the similar lines,

Gurley and Shaw (1955) and Goldsmith (1969) argue that

more developed financial markets promote economic

growth by mobilizing savings to finance the most produc-

tive investments. McKinnon (1973) and Shaw (1973) pro-

vide rigorous theoretical underpinnings to the finance–

growth relationship by arguing that pervasive financial

regulations involving interest rate ceilings and reserve

requirements, especially in developing countries, impede

saving‐investment decisions and stressed the importance

of financial liberalization. The theoretical works of Romer

(1986) and Lucas (1988) contributed to the emergence of

endogenous growth theory by arguing that the financial

sector has a significant role in bolstering growth, particu-

larly by mobilizing savings, efficient resource allocation,

minimizing the information, transaction, and monitoring

costs, diversifying risks, and facilitating the exchange of

goods and services.

The first element of our analysis concerns the pres-

ence of a long‐run relationship between finance–growth.

One strand of literature observes that financial develop-

ment induces faster long‐run growth. Greenwood and

56 SWAMY AND DHARANI