Unveiling the black swan of the finance‐growth Nexus : Assumptions and preliminary evidence of virtuous and unvirtuous cycles

Abstract

Empirical evidence behind the nature of the finance-growth nexus and mediating drivers behind this association is well documented in the literature. However, a framework that depicts the association between credit creation, financial innovation and endogenous creation of boom-bust cycles is less evident and the gap between empirical research and theoretical development remains. Hence, this study represents a first attempt to provide a framework that could explain the switch of economic cycles from virtuous to unvirtuous and vice versa. We examine the role of financial innovation and identify its “hidden soul” defined as the rate of financial innovation (RoFIN). We study RoFIN together with other structural factors, such as monopolistic financial power concentration and financial deregulation in the creation of what we identify as the wealth trap, as a potential mediating factor behind the creation of virtuous and unvirtuous cycles. A cross-country statistical exercise using the VUC indicator on the United States, United Kingdom, and Euro area economies shows the exponential effect of the rate of financial innovation over time and provides indicative evidence in support of our framework. Finally, we report that the indicator is better able to identify the unvirtuous cycle stages than the traditionally used Credit-to-GDP ratio.