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Finance and Growth: When Credit Helps, and When it Hinders

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The financial sector can support growth but it can also cause crisis. The present crisis has exposed
gaps in economists’ understanding of this dual potential.

This paper grounds an alternative approach in the credit nature of money, and in an older distinction between credit flows that grow the economy of goods and services (the GDP), and credit that inflates markets for financial assets and property. This increases the debt-to-GDP ratio and can be a helpful catalyst of the real sector. But if it overshoots, it leads to bloated financial markets and the pursuit of capital gains rather than profit, with rising costs due to high asset values, rising inequality, falling fixed capital formation, rising uncertainty, and fraud and corruption. Unfortunately, overshooting is built into the system due to the nature of money, banking and compound interest. That is why financial deregulation leads to credit booms and busts.