The Nexus between Financial Development and Economic Growth: Evidence from European Countries

Abstract

The subprime crisis brought new challenges for the European countries that’s why this study examines the relationship between banking sector development, stock market development and economic growth, using annual data, for the period 1990-2015, in twelve European Countries (Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain). The principal component analysis was used to construct two new measures (banking sector development and stock market development). The Panel Vector Auto-Regressive model developed by Love and Zicchino (2006) and Granger causalities test was used. Results show that the model is endogenous, stable and that the shocks caused by the introduction of the euro and the subprime crisis are significant. By using dummies tools to control the crisis effects, the banking sector development and the stock market development show a bidirectional relationship. The results suggest that governments should implement stability policies of the banking sector development to attract foreign direct investment that impulses economic growth. Future research that evolves the nexus between financial development and economic growth should take into consideration the impact of the economic crisis in the countries.