More on financial sector choking productivity

By Leith van Onselen

More and more studies are coming to the conclusion that having a large financial sector is actually productivity destroying for an economy and slows its growth.

In May, the International Monetary Fund (IMF) released a report concluding that the larger a country’s financial sector, the bigger its drain on total factor productivity and the greater the risk of economic and financial stability:

…the effect of financial development on economic growth is bell-shaped: it weakens at higher levels of financial development. This weakening effect stems from financial deepening, rather than from greater access or higher efficiency. The empirical evidence also suggests that this weakening effect reflects primarily the impact of financial deepening on total factor productivity growth, rather than on capital accumulation.

When it proceeds too fast, deepening financial institutions can lead to economic and financial instability. It encourages greater risk-taking and high leverage, if poorly regulated and supervised. In other words, when it comes to financial deepening, there are speed limits…

In other words, there is very little or no conflict between promoting financial stability and financial development. Better regulation is what promotes financial stability and development.

This study was followed by research released in early June from economists Stephen Cecchetti and Enisse Kharroubi, who concluded that faster growth in finance is bad for real economic growth. From Business Spectator’s Callam Pickering:

This is readily apparent between 1980 and 2009 — a period in which employment within the financial sector across a range of advanced economies rose at an unprecedented pace. A quick comparison between employment growth in the financial sector and real GDP per worker growth shows a clear downward trend.

The result might surprise some readers. A more developed financial system is supposed to reduce transaction costs, while complicated derivative products were supposed to reduce risk and largely eliminate the business cycle.

But the financial sector competes with other sectors of the economy for resources. It competes for physical capital — such as land and buildings — but also for skilled workers. There is a generation of Americans, Europeans and Australians who have decided to become investment bankers rather than teachers, scientists, or even entrepreneurs.

Then later in June, the OECD entered the fray, releasing a new report arguing that the bloated banking systems in most developed countries are sucking growth out of their economies as well as increasing inequality. The ABC’s Michael Janda summarised the results:

“The empirical analysis documents a link from financial deregulation, measured by an aggregate indicator, to credit expansion and slower growth,” the report found.

“The data indicate that credit intermediaries may have developed in most OECD countries to a point where further expansion is at the margin associated with slower long-term economic growth and greater economic inequality”.

…when loans exceed around 60 per cent of gross domestic product (a key measure of an economy’s output) then further lending actually dents long-term growth.

“An increase from 100 to 110 per cent of GDP is linked to a 0.25 percentage point reduction in economic growth,” the OECD observed.

Now, a new report from economists Stephen Cecchetti and Enisse Kharroubi have found that a booming financial sector slows productivity in industries with either lower asset tangibility or in industries with higher research and development intensity. Financial booms, are therefore, not growth-enhancing. From VOX:

…we broaden the focus to the study of the relationship between financial growth and real growth. Or, more specifically, the effect of changes in the size of the financial system on total factor productivity growth… The faster the financial sector grows, the worse it is for total factor productivity growth. Using panel 20 countries over 30 years, we establish that there is a robust, economically meaningful, negative correlation between productivity and financial sector growth. We also find that causality likely runs from financial sector growth to real economic growth…

Our hypothesis is that it arises because finance tends to favour relatively low productivity industries as such industries usually own assets that are relatively easy to pledge as collateral. So as finance grows, the sectoral composition of the economy changes in a way that drives aggregate total factor productivity down…

Our results are unambiguous. When the financial sector grows more quickly, productivity tends to grow disproportionately slower in industries with lower asset tangibility, or in industries with higher research and development intensity…

Financial booms are not, in general, growth-enhancing. And, the distributional nature of the impact is disturbing, as credit booms harm what we normally think of as the engines for growth – those industries that have either lower asset tangibility or high research and development intensity. This evidence, together with recent experience during the financial crisis, leads us to conclude that there is a pressing need to reassess the relationship of finance and real growth in modern economic systems.

I won’t go over the many reasons why Australia’s bloated financial system is killing the productive economy, since these were explained in detail last month.

All I will say is that Australia’s financial sector has more than doubled its share of the Australian economy since the mid-1980s:

Meanwhile, it has channeled lending away from productive business into unproductive houses (mostly pre-existing):

You can join the dots on that.

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