What Determines the Finance-growth Nexus? Empirical Evidence for Threshold Models Michael Graff and Alexander Karmann Received December 28, 2003; revised version received August 16, 2005 Published online: February 27, 2006 Ó Springer-Verlag 2006 This paper elaborates the notion of ‘‘balanced’’ financial development that is contingent on a country’s general level of development. We develop an empirical framework to address this point, referring to threshold regressions and a bootstrap test for structural shift in a growth equation. We find that countries gain less from financial activity, if the latter fails to keep up with or exceeds what would follow from a balanced expansion path. These analyses contribute to the finance and growth literature in providing empirical support for the ‘‘balanced’’ financial development hypothesis. Keywords: optimum financial activity, thresholds, bootstrapping. JEL Classification: O16, O40, O57. 1 Introduction The literature concerned with finance and growth can be loosely grouped into four groups. A first group takes financial activity and economic growth as causally unrelated phenomena. In this view, the observable correlation between them is spurious. Economies grew, and so did their financial sectors, but the two followed, and continue to follow, their own logic. A second group of economists takes financial activity as the result of ‘‘real’’ economic activity. As the growing scale of economic activities requires more and more capital, institutional raising and pooling of funds are substituted for individual fortunes and retained profits. On the other hand, a third – and now certainly the most prominent – strand of the literature identifies financial activity as a Vol. 87 (2006), No. 2, pp. 127–157 DOI 10.1007/s00712-005-0161-7 Journal of Economics Printed in Austria