Sustained Economic Growth and the Financial System

Franklin Allen and Hiroko Oura

Traditional growth theory does not include financing and suggests that growth will be continuous. In fact, however, growth is often discontinuous. In some periods, there are booms with rapid growth that end in financial crises with low growth for sustained periods. This paper argues that the financial system plays a crucial role in understanding these variations in growth. High growth may require that firms and entrepreneurs take non-diversifiable risks to obtain high returns. This risk taking may lead to high growth but also to frequent crises. Although growth followed by crisis can be beneficial, this is not always the case. When a crisis follows the bursting of a bubble in asset prices, it can have very negative impacts on growth, as in the U.S. Great Depression or in Japan in the 1990s. For sustained growth, policy should be devoted to avoiding bubbles, contagion, and financial fragility.

Key words: Growth; Crises; Bubbles; Contagion; Financial fragility

Views expressed in Monetary and Economic Studies are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

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