Financial Development, Financial Fragility, and Growth

This paper studies the apparent contradiction between two strands of the literature on the effets of financial intermediation on economic activity. On the one hand, the empirical growth literature finds a positive effect of financial depth as measured by, for instance, private domestic credit and liquid liabilities (e.g. Levine, Loayza, and Beck 2000). On the other gates, such as domestic credit, are among the best predictors of crises and their related economic doxwnturns (e.g. Kaminsky and Reinhart 1999). The paper accounts for these contrasting effects based on the distinction between the short - and long-run impacts of financiel intermediation. Working with a panel of cross-country and time-series observations, the paper estimates an encompassing model of short- and long-run effects using the Pooled Mean Group estimator developed by Persaran, Shin, and Smith (1999). The financial intermediation and output growth co-exists with a mostly negative short run relationship. The paper further develops an explanation for these contrasting effects by relating them to recent theoretical models by linking the estimated short-run effects to measures of financial fragility (namely, banking crises and financial volatilitu) and by jointly analyzing the effects of financial depth and fragility inclassic panel growth regressions.