Finance and Growth: The Neglected Role of the Business Cycle

A canonical cross-country/time-series literature argues that finance, measured as private credit, fuels growth. This literature aims to sweep out business cycles by averaging the data over five years. We show that growth and credit are positively correlated with output gap measures for five year averaged data. Studies not adequately controlling for this pro-cyclicality overstate the long-run impact of finance. We illustrate this by controlling for business cycles when estimating growth regressions for a panel of 130 developed and developing countries for the period 1965 to 2009. Once such short-run fluctuations are purged, the impact of credit becomes considerably smaller, and less consistently significant.