Financial sector origins of economic growth delusion

After financial crises, GDP is typically persistently weak compared to pre-crisis trends. We build a simple competitive general equilibrium model to highlight role that the financial sector may have in boosting GDP to unsustainable, undesirable levels before financial crises. Allowing banks to freely trade in financial securities exacerbates the problem. Because loans generate collateral, banks are willing to make lending losses in equilibrium in order to generate trading profit. Our analysis suggests that economists that forecast growth on the basis of time-series trends could be deluded into thinking that the inefficient boost to GDP that derives from an increased ability by the financial sector to exploit such a mechanism is sustainable potential output capacity.