Overend, Gurney & Company was a wholesale discount bank whose head offices were located at 65 Lombard Street, London. It is mostly known for its collapse, occurred in 1866, and the financial crisis it generated in the UK. This single event was the inspiration of a seminal book by Walter Bagehot: “Lombard Street: A Description of the Money Market” (1873). That book is considered the kick off of a debate that is still raging among economists: what is the relation between financial activity and economic growth?
According to Bagehot’s classical view, the financial system is able to foster economic growth by pooling savings and allocating them the most efficient firms. Such view is shared and enriched by Joseph Schumpeter in his 1911 book “The Theory of Economic Development“: financial institutions act as intermediaries between innovative entrepreneurs and owners of capital. Thus, collecting resources and lending them to firms, finance helps to sustain innovation, the engine of economic growth. However, the great depression, and the ensuing collapse of the stock market, led many scholars to cast doubts on the primary role of finance in supporting growth. As argued by Joan Robinson in “The Rate of Interest and Other Essays” (1952): “where enterprise leads, finance follows”.
Thanks to data availability, during the last 30 years a huge stream of empirical literature flourished on the topic. Even if a consensus has not been reached yet, an increasing amount of evidence points to a non-linear, possibly bell-shaped, relation going from financial development to economic growth. That is, the effect of financial development on growth is positive up to a threshold, while it becomes negative afterwards. The issue now is to understand the economic mechanisms that lie behind such a relationship. In that respect, economic theorizing explains the initial positive effect in terms of reduction of market frictions and information asymmetries, while, to account for the detrimental effect of a large financial sector, it proposes misallocation of skilled workers.
Can the whole story amount to a combination of Walter Bagehot’s observations and too many engineers employed as traders? Maybe there is something that in our journey has been left behind. Maybe that something is Schumpeter. That is, much of the theorizing on the topic disregards innovation and how it is carried out. Innovation is performed by firms through trial-and-error processes in an environment characterized by strong uncertainty. Moreover, it features cumulativeness, path dependency, serendipity, and paradigm shifts. This makes equilibrium analysis, the cornerstone of standard economic theory, ill-suited to study innovation. On the contrary, an agent-based approach, building upon evolutionary ideas, might be able to account for the different aspects of innovation.
Thus, in our latest contribution we adopt an agent-based framework, in which innovation is properly modeled, to study the finance-growth nexus. More specifically, we have an economy in which firms produce, imitate already existing highly productive technologies, and innovate exploring the technological space in search of new ones. Since innovation is an expensive activity, a trade-off between exploitation of already known techniques and innovation emerges. Indeed, on the one hand, if no one is looking for new technologies then the economy cannot grow, while, on the other, if too much firms are wasting resources in unfruitful explorations then accumulation is not strong enough to support future rounds of innovation. Thus, a correct balance between exploitation and exploration is needed to ensure endogenous growth. In this frame, adding banks that provide credit to firms willing to imitate or innovate means tilting such balance. In other words, a financial sector may remove firm financial constraints favoring innovative activities. Even if the overall effect of having a financial sector in the economy is positive, when financialization is high exploration overwhelms exploitation and growth is negatively affected. That is, too much finance means a waste of resources because of many unsuccessful innovation attempts. Such simple ideas provide an explanation for the empirically recorded inverted-U shaped relation between financial development and growth, which integrates those already present in the literature.