Reassessing the relationship between the financial sector and economic growth: Dynamic panel evidence

• Author: Constantinos Alexiou,Joseph G. Nellis,Sofoklis Vogiazas
• Published date: 01 April 2018
• DOI: http://doi.org/10.1002/ijfe.1609
• Date: 01 April 2018

RESEARCH ARTICLE

Reassessing the relationship between the financial sector

and economic growth: Dynamic panel evidence

Constantinos Alexiou

1

| Sofoklis Vogiazas

2

| Joseph G. Nellis

1

1

School of Management, Cranfield

University, Cranfield, Bedford MK43 0AL,

UK

2

Black Sea Trade and Development Bank,

Thessaloniki, Greece

Correspondence

Constantinos Alexiou, School of

Management, Cranfield University,

Cranfield, Bedford, MK43 0AL, UK.

Email: constantinos.alexiou@cranfield.

ac.uk

JEL Classification: E44; F43; P26

Abstract

Historically, the development of the financial sector has been an indispensable

driver of economic growth. In the aftermath of the Great Recession, there is a

pressing need to reassess the role of the financial sector in the determination

of economic growth. Using a dynamic panel framework, our analysis covers

34 European and Commonwealth of Independent States economies for the

period 1998–2014 and controls for the role of macroeconomic and institutional

variables. Our evidence suggests that the potential benefits of the financial sec-

tor finance may have dramatically reversed in recent years, resulting in “un‐cre-

ative destruction.”The results suggest, tentatively, that there has been a

severance of the link between the financial sector and the real economy. The

results, however, vary according to the level of economic development across

the European and Commonwealth of Independent States economies. In the

case of developing market economies, the financial intermediation proxies are

not significant in explaining economic growth. The effect of changes in invest-

ment expenditure, the money supply, wages, unit labour costs, and trade open-

ness is found to be strong and in line with a priori expectations across all

country samples. Notably, government consumption is also found to be a signif-

icant driver of economic growth, except in the developing market economies in

the period following the Great Recession. In line with the growing consensus in

other research areas, we provide evidence of a robust role for the institutional

framework proxied by the quality of governance in determining economic

development.

KEYWORDS

CIS, economic growth, European economies, financial sector

1|INTRODUCTION

The efficiency of the financial sector in a country is a

major determinant of macroeconomic performance. This

has been clearly manifested in the aftermath of the Global

Financial Crisis (GFC) of 2007–2008 and the subsequent

Great Recession suffered by many developed and develop-

ing economies. At the same time, sustained economic

growth remains the single most important determinant

of societal living standards (Haldane, 2015). Although

the empirical research on the finance‐growth nexus has

grown in the aftermath of this period, the evidence relat-

ing to the European and Commonwealth of Independent

States (CIS) economies has been relatively scarce and with

mixed results. The GFC had severe implications for the

financial markets and the economic growth of these

Received: 21 September 2015 Revised: 9 May 2016 Accepted: 19 December 2017

DOI: 10.1002/ijfe.1609

Int J Fin Econ. 2018;23:155–173. Copyright © 2018 John Wiley & Sons, Ltd.wileyonlinelibrary.com/journal/ijfe 155

regions, substantiating the argument that the relationship

between finance and growth is complex and not necessar-

ily stable over time (Grochowska, Diaconescu, Margerit,

& Tomova, 2014). Thus, the classic question re‐emerges

as sclerotic growth remains the overriding economic issue

of our time (Cochrane, 2015), especially for a number of

the countries examined in this paper. Although the finan-

cial sector is crucial for the functioning of the real econ-

omy, the exact contribution to growth remains uncertain

and varies over the business cycle. In this paper, we

explore the possibility that the role of the financial sector

in terms of its impact on the economy may have funda-

mentally changed in recent years, controlling for the

effect of changes in investment expenditure, wages, unit

labour costs, domestic credit, the money supply, the inter-

est rate margin, government consumption, inflation, and

trade openness.

To explore the role that the financial sector plays in

economic growth, one needs to take into account “fric-

tions”in order to develop a deeper and clearer under-

standing of the mechanisms in operation (Aghion &

Howitt, 2009). Mumtaz, Pinter, and Theodoridis (2015)

provide evidence that the credit supply shock in the after-

math of the GFC made a large and significant contribu-

tion to the decline in gross domestic product (GDP)

growth and inflation in the years that followed, suggesting

that frictions associated with financial intermediation

play a key role in propagating shocks that drive macroeco-

nomic fluctuations. To explore how the relationship

between the financial sector and economic growth may

have changed over time across Europe and the CIS prior

to and following the GFC, we group countries into three

subsamples: advanced, developing markets, and the

eurozone.

Our results suggest that all of the control variables

(investment expenditure, wages, unit labour costs, domes-

tic credit, the money supply, the interest rate margin, gov-

ernment consumption, inflation, and trade openness)

exert a significant role in determining economic growth.

Also, our results indicate significant variation in this role

across the three subsample groups, suggesting that the

finance‐growth nexus depends materially on the level of

economic development. Specifically, in the case of the

developing market economies, the proxies for financial

sector intermediation (domestic credit and interest rate

margin) are found to be insignificant in explaining eco-

nomic growth over the period under investigation

(1998–2014). Furthermore, we find significant variation

between advanced and the eurozone economies with

respect to the effect of changes in unit labour costs, gov-

ernment consumption, and inflation. Irrespective of the

classification of countries, our results indicate that institu-

tional quality is a significant driver of economic growth.

Thus, good governance does play a critical role in deter-

mining the ability of economic agents to operate in a

growth‐friendly manner.

The rest of the paper is structured as follows: Section 2

reviews the research literature on the finance‐growth

nexus. Section 3 presents the data and methodology

employed in this study, whereas Section 4 sets out as well

as discusses the empirical results. Finally, Section 5 pro-

vides some concluding remarks.

2|LITERATURE REVIEW

The intermediating role of the financial sector is so

ingrained in the functioning of economies that one may

wonder about the need to investigate its importance for

the economy (Cetorelli, 2009). Nonetheless, the debate

on the determinants of the process of economic growth

and the role of the financial sector has been active for over

a century. The central question in this debate is whether

or not the performance of the financial sector is a funda-

mental driver of economic growth or merely the conse-

quence of growth (Aghion & Howitt, 2009). If finance

interacts with growth, then it is worth exploring the

mechanisms underlying this relationship and the implica-

tions for macroeconomic policy—particularly as the

existing state of knowledge in this field is frequently

ignored or “inconvenient realities”are played down (Baily

& Elliott, 2013, p. 5). Although economists attach differ-

ent degrees of importance to financial development, its

role in contributing to long‐term economic growth can

be theoretically postulated; this has been supported by

the findings of growth empirical studies (Ang, 2008).

On the theoretical front, two pioneering economists

that have examined the importance of the relationship

between finance and growth were Bagehot (1873) and

Schumpeter (1911). Bagehot (1873) emphasized the criti-

cal role of the banking system in economic growth and

highlighted the conditions under which banks could spur

on innovation and growth by funding productive invest-

ments. In Schumpeter (1911), the argument put forward

was that financial services are paramount in promoting

economic growth. Later, Robinson (1952) argued that

financial development follows growth and articulated

the causality argument by suggesting that “where enter-

prise leads, finance follows.”Although growth may be

constrained by credit creation in less developed financial

systems, in more sophisticated systems,

1

finance is viewed as an endogenous response to

demand requirements. In a reconciling manner, Patrick

(1966) uses the supply‐leading and the demand‐following

2

set of hypotheses to describe the finance‐growth relation-

ship suggesting that both hypotheses can be applied in a

156 ALEXIOU ET AL.