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February 26th, 2015 at 2:54 pm

Warning: rapid finance sector growth is bad for the economy

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One huge political issues in recent years has been that Wall Street has done better than Main Street.  the Bank for International Settlements has a new study that shows exactly why rapid finance sector growth is bad for the rest of the economy.

The study, by Stephen Cecchetti and Enisse Kharroubi, is a follow-up to a 2012 paperwhich outlined the negative link between the finance sector and growth, after a certain point. When an economy is immature and the financial sector is small, then growth of the sector is helpful. Enterprising businessmen can get the capital they need to expand their companies; savers have a secure home for their money, making them more willing to provide finance to the business sector; and so on.

But you can have too much of a good thing. The 2012 paper suggests that when private sector debt passes 100% of GDP, that point is reached. Another way of looking at the same topic is the proportion of workers employed by the finance sector. Once that proportion passes 3.9%, the effect on productivity growth turns negative. Ireland and Spain are cases in point. During the five years beginning 2005, Irish and Spanish financial sector employment grew at an average annual rate of 4.1% and 1.4% respectively; output per worker fell by 2.7% and 1.4% a year over the same period.

The new paper examines why this might be. One part of the thesis is a familiar complaint, neatly summarised in the 2012 paper

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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

In short, the finance sector lures away high-skilled workers from other industries. The finance sector then lends the money to businesses, but tends to favour those firms that have collateral they can pledge against the loan. This usually means builders and property developers. Businessmen are lured into this sector rather than into riskier projects that require high R&D spending and have less collateral to pledge. On a related note, see our recent Free Exchange on how bank lending has become more focused on residential property.

A property boom then develops. But property is not a sector marked by high productivity growth; it can lead to the misallocation of capital in the form of empty Miami condos or Spanish apartments. In a sense, this echoes the research of Charles Kindleberger who showed that bubbles are formed in the wake of rapid credit expansion or Hyman Minskywho argued that economic stability can lead to financial instability as financiers take more risk. And it reinforces the recent McKinsey report which shows that too much total debt (not just government debt) can be bad.

In specific terms, the authors suggest that

R&D-intensive industries – aircraft, computing and the like – will be disproportionately harmed when the financial sector grows quickly. By contrast, industries such as textiles or iron and steel, which have low R&D intensity, should not be adversely affected

The paper looks at two indicators for finance sector growth – the ratio of bank assets to GDP and that of total private credit to GDP. For industries, they examined financial dependence (the need for outside capital to finance growth rather than retained cashflows) and the R&D intensity. They find quite a large effect.

The productivity of a financially dependent industry located in a country experiencing a financial boom tends to grow 2.5% a year slower than a financially independent industry not experiencing such a boom.

This is highly significant, given that most developed economies would love to gain 2.5 points of productivity especially in a world where demography may be constraining growth.

As the authors conclude

there is a pressing need to reassess the relationship of finance and real growth in modern economic systems

This seems right given the whole focus since 2008 has been about reviving and stabilising the banking sector so it can lend to small businesses. Instead (or at least as well) it should have been about channelling finance to those industries that can expand and employ more workers. On this point, it is encouraging that the European Commission has issued a green paper on capital markets union today, hoping to diversify the financing of small businesses away from banks. But perhaps the last word should be left to Winston Churchill, who spotted this problem nearly 90 years ago when he said that

I would rather see finance less proud and industry more content

 

Image credit: StockMonkeys.com
Via The Economist

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