A well-functioning financial sector is essential for economic growth: as long as entrepreneurs and businesses have opportunities that require outside financing, there will be a need for finance.
But when does financial growth stop being a good thing, or even become a drag on innovation and growth? Previous research shows that when lending reaches around 100 percent of GDP, the relationship between credit and productivity growth starts to invert. Why is this the case? A new paper by Stephen G. Cecchetti and Enisse Kharroubi offers an explanation:
We examine the negative relationship between the rate of growth in credit and the rate of growth in output per worker. Using a panel of 20 countries over 25 years, we establish that there is a robust correlation: the higher the growth rate of credit, the lower the growth rate of output per worker. We then proceed to build a model in which this relationship arises from the fact that investment projects that are more risky have a higher return. As their borrowing grows more quickly over time, entrepreneurs turn to safer, hence lower-return projects, thereby reducing aggregate productivity growth. We take this theoretical prediction to industry-level data and find that credit growth disproportionately harms output-per-worker growth in industries that have either less tangible assets or are more R&D-intensive.
Since firms make investment decisions based not only their current ability to borrow, but also on their future ability to borrow, a rapid increase in credit growth at one time period will encourage riskier investments, but the riskiness of those investments means firms will need to invest in lower-risk, lower-reward projects in the future.
Another interesting finding of their paper is the disparity between firms with more tangible versus intangible assets (such as goodwill, R&D, and human capital). Because firms with a greater share of tangible assets are better able to “pledge” their output as collateral, they are able to borrow more easily and benefit disproportionately from a growing financial sector, compared to firms that are more R&D-focused.
When comparing the effect of a credit boom on R&D versus non-R&D intensive industries, the authors find “that a highly R&D-intensive industry located in a country with a rapidly growing credit will experience growth in value-added per worker that is roughly 2 to 2½ percentage points per year less than an industry that is not very R&D-intensive located in a country with a slow-growing credit.”
Higher debt accrued at one time period can become a drag on productivity when it forces firms to scale back the scope of their investments in a later time period. When these effects are more pronounced in R&D-intensive industries, it should signal to policymakers that policies to curb increased debt driven by financial-sector growth may be necessary to increase innovation. Business cycles are a feature of developed market economies, but this paper shows there are consequences to long-run growth when boom times are fueled by a credit boom.
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