The Impact of Financial Crises on the Finance-Growth Relationship: A European Perspective

Rousseau and Wachtel (2011) (Rousseau, P., Wachtel, P., 2011, 'What is Happening to the Impact of Financial Deepening on Economic Growth?' Economic Inquiry, 49(1), pp. 276-288) find a weakening effect of bank finance on growth for more recent periods in replicating King and Levine (1993) (King, R. G., Levine, R., 1993, 'Finance and Growth: Schumpeter Might Be Right', The Quarterly Journal of Economics, 108, pp. 717-737) in a heterogeneous sample up to 2004. We contribute by re-examining this finding for a focused set of 26 European countries up to 2009. In the second step, we introduce an aggregated finance variable into the model which accounts for aggregate credit, bond and stock markets. We reconfirm a weakening effect of finance on growth, which is persistent even when dummy variables are added to control for financial crises. The development of European financial markets seems to have not only decoupled from the real sector but also to exert an inverted impact on growth. We attribute our finding to structural change between bank-and market-driven setup, threshold effects and the procyclical nature of financial markets.