Thresholds: Finance, Growth & Institutions

By Ferdinand Folland

Pierson's Politics in Time (2004) outlines several forms of long-term processes, one of which is “Threshold Effects”. Threshold effects are a category of long-term processes in which the causal time horizon is long, while the time horizon for their outcomes are “short” or rapidly unfold. Essentially it is a process in which there is a slow build-up, during which the effects are small or non-existent, until one passes a threshold at which the effects drastically change and/or rapidly unfold. One case which illustrates such mechanisms may be the influence of institutions on the relationship between financial development and economic growth.

This is based on a paper by Law, Azman-Saini and Ibrahim. In their paper they start by review some of the literature on the topic of financial development and its effects on economic growth. They highlight the fact that most research display substantively different results for high-income and low-income countries. The authors proceed to suggest institutions as the omitted variable. Through regression analysis and threshold estimation techniques they research the interaction effects between financial development and the subsequent effect on economic growth. In this research they show how financial development, or development of the financial sector, does not affect economic growth, in any noteworthy or statistically significant sense, unless the institutional quality is at a particular level. Their empirical results provide interesting insight into why financial development can have such different effects across countries, while also illustrating threshold effects in the case of institutions.