Where does credit go? Why more lending does not always create real economic growth

What is it about?

Does more credit always lead to inflation? Standard economic thinking often assumes that when lending expands, prices will rise. But the reality is more nuanced. This study examines how credit affects economic outcomes across countries over the past three decades. The key insight is that the impact of credit depends on how well an economy can absorb and use it productively. In countries with strong institutions and sufficient infrastructure, credit can support business activity, investment, and the production of goods and services. In these cases, it contributes to real economic growth. However, when institutional quality is weak or productive capacity is limited, credit is more likely to increase short-term demand without expanding supply. This can lead to higher prices, asset bubbles, and greater reliance on imports rather than sustainable growth. To capture this mechanism, the study introduces a new indicator, the LRAS-Leaning Barometer (LLB). The LLB helps track whether credit in an economy is being channelled toward productive capacity (supporting long-run growth) or toward demand pressures (increasing inflation and asset prices). Using this framework, the analysis identifies a broader global pattern since around 2010. The relationship between credit expansion and real economic growth appears to have weakened. Instead, additional credit is increasingly associated with demand pressures and rising asset prices. This shift is referred to as the “Great Decoupling”. These findings suggest that policymakers should look beyond the total volume of credit and pay closer attention to how and where it is allocated. Strengthening institutions, improving infrastructure, and ensuring that financial resources support productive investment are essential for achieving sustainable economic growth.

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Photo by KOBU Agency on Unsplash

Photo by KOBU Agency on Unsplash

Why is it important?

This research shows that expanding credit alone is not sufficient for sustainable economic growth. When financial resources are not channelled into productive investment, they are more likely to drive inflation and asset prices rather than strengthen the real economy. The study introduces the LRAS-Leaning Barometer (LLB), which helps identify whether credit is supporting productive capacity or fuelling demand pressures. The findings highlight the importance of improving institutional quality, infrastructure, and financial allocation mechanisms so that credit contributes to long-term growth. This has direct implications for monetary policy, financial regulation, and development strategies, particularly in developing and transition economies.

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