Too Much Finance: Mechanisms That Harm Growth and Policy Implications

The mechanisms for the financial sector to harm growth arise through short-termism of financial markets. This leads to the misallocation of resources in the private sector, leading to financial crises and damage to growth. However, harm to growth comes not only from financial crises, but also from the failure of short-termist financial markets to facilitate public investment in long-term, growth-enhancing projects. While the literature has discussed the first channel extensively, it is largely silent on the second one. Our contribution is to develop a formal model to clarify how investment reticence of governments can arise from the fear of financial crises. A central conclusion is that in the presence of a large financial sector, the fear of market turmoil can damage growth even in the absence of an actual crisis episode. We discuss policy responses to both mechanisms.