Finance and Growth: An Analysis of Causality for Cointegrated Panels

2 The relationship between finance and economic growth has been a source of research interest over the past century. This paper applies a panel cointegration based test for long-run causality from Pedroni and Canning (2008) to the finance-growth field for the first time. The methodologies used are robust to endogeneity, omitted variable bias, and reverse causality, while allowing for heterogeneous long-run cointegrating relationships and short-run dynamics across panel members. An analysis of three bivariate cointegrating relationships between proxies for the size of a financial system and GDP per capita reveals that bi-directional long-run causality exists pervasively among panel members. This finding confirms a diverse set of recent empirical work in the finance-growth field and contributes a new long-run causal perspective. In addition, a test for the sign of this causal relationship relative to a growth maximizing point indicates that panel members are pervasively overinvested in the size of financial systems