The Bank for International Settlements (BIS) has released a new report examining the negative relationship between the rate of growth of the financial sector and the rate of growth of total factor productivity.
The report finds that growth in the financial sector reduces an economy’s total factor productivity growth by disproportionately benefiting high collateral/low productivity projects, such as housing:
In this paper, we study the real effects of financial sector growth and come to two important conclusions. First, the growth of a country’s financial system is a drag on productivity growth. That is, higher growth in the financial sector reduces real growth. In other words, financial booms are not, in general, growth-enhancing, likely because the financial sector competes with the rest of the economy for resources. Second, using sectoral data, we examine the distributional nature of this effect and find that credit booms harm what we normally think of as the engines for growth – those that are more R&Dintensive. 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.
The BIS’ conclusions are similar to those of fellow MB blogger, Cameron Murray, who in 2012 estimated that a considerable slice of Australia’s declining multi-factor productivity has resulted from escalating land prices.
Land is a key input cost for most businesses. So when costs are inflated, it reduces the competitiveness of industry, making it harder for Australia to compete abroad. The associated higher housing costs also places upward pressure on wages.
For decades, resource allocation in Australia has been channeled away from the tradable sector and infrastructure investment towards the financial sector, as home buyers have taken on ever-bigger mortgages as they chased house prices higher. It should be no surprise that the finance and insurance industries – which are dominated by mortgage lending – have grown at more than twice the pace of the rest of the economy since financial markets were deregulated in the mid-1980s, due in part to the housing quango operated by the various levels of government (see below charts).
In fact, the finance and insurance sector hit the highest share of GDP on record (8.55%) in the September quarter of 2014. This corresponds with Australian real house prices, which decoupled from rents long ago and hit their highest ever level in the December quarter of 2014 (see next chart).
Australia’s housing obsession has also starved productive sectors of the economy of credit. In the early 1990s, Australia’s banks lent nearly two-thirds to businesses, with the balance split between housing and personal lending. However, after the mid-1990s explosion of housing values, these ratios have reversed, with housing lending dominating at the expense of businesses (see next chart).
Again, the proportion of loans to housing (60.74%) hit a record high in December 2014, whereas the share of loans to businesses (33.18%) hit a record low.
At the heart of the problem are Australia’s unique mix of tax concessions, such as negative gearing and capital gains tax concessions, and the constipated supply system. The former has increased the relative attractiveness of housing investment, boosting demand, whereas the latter has materially dampened the supply response. The end result is too much of the nation’s capital tied-up in housing, which has chocked-off productive areas of the economy.
In its December house price release, the ABS valued Australia’s housing stock at a whopping $5.4 trillion, or around 3.4 times GDP.
One can only wonder how Australia would have looked if the many billions of dollars of excess capital that has been poured into pre-existing housing had instead been funneled into businesses and infrastructure, as occurs in places like Germany. Instead, Australia has been left with hollowed-out industries, non-mining companies that are struggling to compete, and an infrastructure deficit that will likely never be closed, made worse by rampant population growth (immigration).
Policy makers must now place competitiveness front-and-centre and, among other things, change the tax system so that it rewards productive investment, as well as liberalise the myriad of constraints across the supply-side of the economy that have forced-up cost structures, most importantly in land.
Otherwise, we again risk becoming the “white trash” of Asia once the easy riches from the once-in-a-century commodity boom washes through.