Financial stability and economic performance

•We assess the link between economic performance and financial stability in the EU from 1998 to 2011;•We use the standard framework of Beck and Levine (2004);•We estimate this causal relationship, independently from but controlling for the level of financial depth;•We find that financial instability has a negative impact on economic performance;•Various indicators of economic performance, financial depth and financial instability are tested.

This paper aims at establishing the link between economic performance and financial stability in the European Union. We use the seminal framework of Beck and Levine (2004) - both in terms of variables and econometric method - to estimate this causal relationship, independently from but controlling for the level of financial depth. Using a panel GMM with instrumental variables, our contribution involves testing how different measures of financial instability (an institutional index, microeconomic indicators, and our own statistical index derived from a principal component analysis) affect economic performance (or components of aggregate dynamics like consumption, investment and disposable income). We find that financial instability has a negative effect on economic growth.