Schumpeter might be right again: the functional differentiation of credit

In contemporary research, it is common to measure growth-enhancing financial development by the volume of credit as a ratio of the gross domestic product (GDP), an application of Schumpeter’s theory of credit and development. Recently, researchers have been surprised to find a negative relation between this measure and economic growth. This paper has three aims. First, Schumpeter sharply distinguished between the volume of credit financing development and the (typically larger) volume of the ‘secondary wave’ of credit financing consumption, over-investment and speculation, which follows the ‘primary wave’ of credit financing innovations. Combined with circuit theory, this helps explain the growth and the effects of credit/GDP ratios in our time. Second, it is shown that an increase in the credit/GDP ratio is due to an increase in ‘secondary wave’ credit, not productive credit; and since credit is debt, growth in the credit/GDP ratio is negative, not positive for economic development. Third, five contemporary ways in which the use of credit for consumption, financial investment and speculation has been institutionalized are discussed. The message of this paper is that, as Schumpeter wrote, “distinction between debts according to purpose, however difficult to carry out, is always relevant to diagnosis and may be relevant to preventive policy”.