The Causal Relationship between Banking, Capital Markets and Economic Growth in the European Union

The current paper investigates the causal relationship between financial development and economic growth in 27 European Union (EU) countries. Granger causality tests are applied, using the cointegration and Vector Error-Correction (VEC) methodology. Through the empirical analysis, we found evidence of the presence of Granger causality between finance and growth, sometimes even bi-directional causality, but the nature of the relationship is far from uniform across EU countries. Therefore, a one-size-fits-all approach of policymakers may not be effective for the financial sector to drive economic growth. The results suggest that there are different interactions between the financial sector and economic expansion, based on country specifics, as the causality is sustained by the banking sub-sector in some cases, especially in the case of countries that were part of the former communist bloc, and it is driven by the capital market in other cases. There are also cases in which both financial sectors Granger cause economic growth mostly in the countries that succeeded to better diversify their sources of funding. These findings highlight the presence of financial structural differences among EU countries, and, at the same time, the importance of tailored policies to support further economic expansion.