Over the past 20 years, economists have accumulated a substantial body of empirical evidence that financial sector deepening is a critical part of the economic development process. This shows a well-functioning financial system is a conditio sine qua non for modern market economies to flourish. What started with simple cross-country regressions, as used by King and Levine (1993), has developed into a large literature using an array of different techniques to look beyond correlation and controlling for biases arising from endogeneity and omitted variables. These studies provided a consistent result – financial deepening is a critical part of the overall development process of a country (see Levine 2005, for an overview and Beck 2009, for a detailed discussion of the different techniques).
The findings of this literature, however, sit uncomfortably with the recent experience of many developed countries. It is not just the Global Crisis of 2007/8 that has shed doubts on the finance-growth paradigm, but there are more fundamental questions on the relationship between financial development and economic growth. Aghion et al. (2005) show that the relationship turns insignificant at higher levels of economic development, while Arcand, Berkes and Panizza (2012) show that the relationship even turns negative at very high levels of financial development.
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