Is finance a drag on economic growth?

Is it time to get off the money-go-round?

Do advanced economies chew up too much money and talent in their banking and finance industries – and is that slowing down their economies?

By Chris Wright

It took a global financial crisis and a fair deal of reflection, but the finance industry today is under more serious scrutiny than at any time in the past four decades. An increasing number of economists say that in developed economies, modern finance has become too large. Finance, they say, can be a drag on growth rather than a catalyst for it.

In particular, critics worry that in many developed nations, finance has reached the point where it drains talent that might be usefully applied elsewhere – that it brings risk and volatility where it ought to bring stability, and that banks enrich themselves at the expense of their societies, rather than in support of them.

Some economists point to the US finance industry, which on one estimate grew from an estimated 4.9 per cent of the nation’s GDP in 1980 to 7.9 per cent by 2007 and is bigger now. Australia’s finance sector may be proportionally even larger.

Concern over the size of the finance sector in advanced economies was raised last year courtesy of Luigi Zingales, a professor at the University of Chicago’s Booth School of Business. Zingales, then also president of the American Finance Association, gave a much-noticed speech, “Does Finance Benefit Society?”. 

He didn’t reject finance’s usefulness, but he did urge his colleagues to listen harder to criticism from the public. Finance, he warned, could easily degenerate into an activity which made money for the players without providing anything to society.

“While there is no doubt that a developed economy needs a sophisticated financial sector,” he said, “there is no theoretical reason or empirical evidence to support the notion that all the growth of the financial sector in the last 40 years has been beneficial to society. An industry does not pay $139 billion in fines in two years if there is nothing wrong.”

Moving in other directions

Across the Atlantic, UK economist John Kay has been working towards a more sweeping conclusion. Late last year, he published Other People’s Money: Masters of the Universe or Servants of the People?. It starts out by recounting, with increasing incredulity, the numbers around the British banking sector – which is by no means the world’s biggest.

For instance, how is it that the value of daily foreign exchange transactions is nearly 100 times that of daily international trade in goods and services? How can it be that the value of assets underlying derivatives contracts is three times the value of all the physical assets in the world?

One reason is that banks don’t, in the main, spend their time doing what most people think they are doing. Kay says that lending to firms and individuals engaged in the production of goods and services – which most people would imagine was the principal business of a bank – amounts to about 3 per cent of bank assets or liabilities in Britain.

Most bank assets are actually claims on other banks, and most bank liabilities are just obligations to the same banks. Banking today is chiefly a lot of electronic money going round in circles, he concludes.

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In younger financial systems, there’s little doubt that banking continues to have great value.

“Modern societies need finance,” says Kay. When industrialisation got started in places like Britain and the Netherlands, it did so at the same time as the development of finance, and the relationship is not coincidental. The link can be proven by exception: in communist states that suppressed financial systems such as (then) Czechoslovakia and East Germany, their economies lagged.

The question is whether this effect has limits. Kay thinks it does. He identifies four ways in which banking is meant to contribute to a society: the payments system, through which we receive wages and buy goods and services; matching lenders with borrowers, thereby directing savings to their most effective uses; helping us manage our personal finances through our lifetimes and between generations; and helping both individuals and businesses to manage risks associated with everyday life. Then he asks: how much time does modern finance spend on meeting these four basic needs? His answer: not that much.

"Banking today is chiefly a lot of money going round in circles." John Kay

“Financial innovation was critical to the creation of an industrial society,” writes Kay.

“It does not follow that every modern financial innovation contributes to economic growth. Many good ideas become bad ideas when pursued to excess.”

The bell curve

How financial development affects GDP growth - the IMF viewIndeed, the International Monetary Fund (IMF) – hardly a contrarian or revolutionary when it comes to international finance – believes it has identified the point at which this transition from engine of growth to draining obstacle takes place. 

In May last year, 12 IMF researchers published a report, Rethinking Financial Deepening: Stability and Growth in Emerging Markets. It looked at the development of finance in emerging markets, studying 128 countries between 1980 and 2013.

In practical terms, it found that a country such as Poland is in the sweet spot. Morocco is approaching it; Ireland has just left it; and the US and Japan have left it far behind.

“Financial development increases growth,” the paper concluded, “but the effects weaken at higher levels of financial development and eventually become negative.” The effects trace out a bell-shaped path. The IMF report also says that financial development has speed limits: go too fast and it becomes destabilising.

Others have tried similar calculations. The Organisation for Economic Co-operation and Development (OECD) issued a paper last year by researchers Boris Cournède and Oliver Denk that reached essentially the same conclusions.

At the Bank for International Settlements, the peak body for the world’s central banks, economist Stephen Cecchetti was like-minded, calling finance “a two-edged sword” with a threshold beyond which it becomes a drag.

In his view, this threshold is about debt: “Productivity grows more slowly when a country’s government, corporate or household debt exceeds 100 per cent of GDP,” he wrote. Zingales has come up with a similar figure.

The three burdens of finance

How then, specifically, does finance burden an economy when it gets too big? The IMF found three burdens. One is that too much finance increases the frequency of booms and busts, leaving a country worse off in the aggregate and suffering too much volatility along the way.

Another is that finance steers talent away from productive sectors and from other vital services, such as medicine and education. The third is that “a very large financial sector may be particularly susceptible to moral hazard or rent extraction from other sectors, both of which would lead to a misallocation of resources”.

In other words, it’s not just that bankers are getting unfairly rich; it’s that it costs other sectors and society itself in order to enable that wealth.

The IMF was especially articulate about the damage that finance might do to the talent pool: “People who might have become scientists, who in another age dreamt of curing cancer or flying to Mars, today dream of becoming hedge fund managers,” it noted.

"Finance steers talent away from productive sectors." IMF Report

Head of the IMF Christine Lagarde followed up on the IMF report in a speech last year. “When financial sector development outpaces the strength of the supervisory framework, there is excessive risk taking and instability,” she said.

“The experience in many countries, including in the United States, has exposed the dangers of financial systems that have grown too big too fast.”

Reserving their judgement

Not everyone is so sure about the dangers of too much finance. Economist William Cline has critiqued the OECD paper’s results as, essentially, a “statistical illusion”. The governor of the Reserve Bank of Australia, Glenn Stevens, has previously pointed to the potential dangers of an inflated finance sector – but he has also noted that services are growing more important in the economy, so that we might expect some growth in finance over time.

More broadly, the strongly market-oriented US economist John Cochrane has warned policy analysts against condemning the growth in finance until they know more. In a 2013 article, he cautioned that “I don’t understand it” doesn’t mean “it’s bad”.

Instead of trying to determine exactly the right size for the finance sector, he suggests we should find out whether the market mechanisms that usually work so well are really failing in finance.

If they are, we can figure out why and start to fix the problem. Cochrane preceded Zingales as president of the American Finance Association and his views carry weight. The debate is not yet over.

Will finance shrink?

If finance does harm growth, what is to be done? Perhaps in some sense, the problem will prove to be self-fulfilling. If banks and asset managers stop making profits in the same way they used to – and bank profitability in particular is under major threat all over the world – then the brightest minds in the business may decide their bonuses are no longer so attractive and will try their hands in other industries. 

“Finance is not special,” concludes Kay, “and our willingness to accept uncritically the proposition that finance has a unique status has done much damage.” 

If finance doesn’t shrink, scrutiny of it is set to grow.

Read next: Banking facing pressure to adapt in changing marketplace


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