Financial sector origins of economic growth delusion∗

After financial crises, GDP is typically persistently weak compared to pre-crisis trends. We build a simple competitive general equilibrium model to highlight role that the financial sector may have in boosting GDP to unsustainable, undesirable levels before financial crises. Allowing banks to freely trade in financial securities exacerbates the problem. Because loans generate collateral, banks are willing to make lending losses in equilibrium in order to generate trading profit. Our analysis suggests that economists that forecast growth on the basis of time-series trends could be deluded into thinking that the inefficient boost to GDP that derives from an increased ability by the financial sector to exploit such a mechanism is sustainable potential output capacity. WORK IN PROGRESS Please check http://faculty.london.edu/fmalherbe for update, or click this link for the latest version. ∗We would like to thank Mark Hassler for his discussion comments as well as seminar participants at the CEPR Economic Growth Conference, London Business School, University of Amsterdam, Universita Carlos III, Universite libre de Bruxelles, the Bundesbank, and the Reserve Bank of New Zealand for their useful feedback. Work in progress. Please do not circulate. †London Business School and CEPR ‡University of Warwick, CEPR, CAGE (Warwick), CfM (LSE), and CAMA (ANU).