Is financial development good for economic growth? Empirical insights from emerging European countries

The impact of financial development on economic growth has been extensively debated in the literature since the seminal paper of Schumpeter (1934) considering finance as an engine of economic growth through its effects on innovative investments. However, recent empirical literature casts some doubts on this relationship and repcorts a minor role of financial development in driving economic growth or the existence of a non-monotone linkage between financial development and economic growth. The paper investigates empirically this relationship for 11 Emerging European Countries (EEU) on the period 1995-2016 by using dynamic panel models (such as the Pooled Mean Group estimator of Pesaran et al. 1999). The findings, when imposing a linear relationship, suggest that financial development produces positive effects on economic growth only in the short-run horizon (validating the supply leading channel). When studying the hypothesis of non-linearities related to the finance-growth nexus, the relationship has an inverted U-shaped form (financial development exerts a positive effect on economic activity until a certain threshold and after that, the link becomes negative). The non-linearity hypothesis is true only for the domestic credit to private sector variable. In terms of policy implications, the governments should focus on efficient investment projects to improve economic growth and to efficiently expand the banking sector.