IMF declares FIRE sector a growth killer

The IMF has come a long way:

Financial development increases a country’s resilience and boosts economic growth. It mobilizes savings, promotes information sharing, improves resource allocation, and facilitates diversification and management of risk. It also promotes financial stability to the extent that deep and liquid financial systems with diverse instruments help dampen the impact of shocks. But is there a point beyond which the benefits of financial development begin to decline and costs start to rise, and have emerging markets (EMs) reached these limits? This paper takes stock of where EMs are on the stability-growth tradeoff that financial development entails, and considers whether there is further scope for financial development, and how EMs can secure a safe process of financial development.

The 2008 global financial crisis raised some legitimate questions about financial deepening and financial development, given that the crisis originated in advanced economies (AEs), where the financial sector had grown both very large and very complex. Are there limits to financial development for growth and stability? Is there a right pace of development? Are there tradeoffs? What is the role of institutions in promoting a safe financial system? Are there lessons for EMs from AEs’ experience to reap the benefits from financial development, while avoiding the pitfalls? In this regard, this study provides five key policy-relevant findings:

1234First and foremost, using a new, broad, measure of financial development, this study underscores that many benefits in terms of growth and stability can still be reaped from further financial development in most EMs. Financial development is defined as a combination of depth (size and liquidity of markets), access (ability of individuals to access financial services), and efficiency (ability of institutions to provide financial services at low cost and with sustainable revenues, and the level of activity of capital markets).

Second, 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.

3The third and related finding of the study is that the pace of financial development matters. 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. This puts a premium on developing good institutional and regulatory frameworks as financial development proceeds.

The fourth finding relates to the potential tradeoffs of financial regulation. One view is that tighter and more regulation to help safeguard financial stability can hamper financial development. This study provides a new angle. It finds that, among a large number of regulatory principles, there is a small subset that is critical for financial development as well as for financial stability. 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.

The fifth finding is that there is no “one-size-fits-all” in the sequencing of developing financial institutions versus markets, though as economies evolve the relative benefits from institutions decline and those from markets increase.

The study does not look at Australia, sadly, but if it did it would find precisely the same relationship between financial deepening and falling total factor productivity. In fact we would be a case study for it, and have been rescued from by terms of trade booms.

But those are now reversing…

Full report.

Houses and Holes

David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the fouding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.

He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.

Comments

  1. It is absolutely expected outcome of FIRE sector growth. FIRE is aucking the life from the real economy and the wealth and income of the middle class. What is surpising, or maybe not, is how it has taken to IMF to see the reality.

  2. Don’t tell that to London… its the only thing keeping that island afloat!

    • and this island too. It’s not the tide that’s rising, it’s the country sinking.

  3. The real issue with financial ‘deepening’ in developed countries in recent decades is that financial sectors have ceased primarily acting as intermediaries directing capital to productive investments, and instead begun acting as facilitators of final consumption demand.

    Due to a variety of global factors, developed world households have not enjoyed sufficient income growth to clear the international goods market (or more accurately, income growth has been too concentrated to generate adequate final consumption demand). Financial sectors have plugged this gap by lending to households.

    • SoMPLSBoyMEMBER

      Good point MJV
      “Financial sectors have plugged this gap by lending to households”. I think the ‘gap’ was not accidental and fully engineered by said lenders and I worry when ‘that’ gap has reached its limit, a new ‘gap’ will be engineered to keep the debt machine ticking along. Some ( and I struggle to ‘accept’ that this ‘is’ happening but accept it ‘could’ happen) suggest that the final frontier for lenders is the deliberate ‘wounding’ of this planet for the business’ opportunities’ this would present.

  4. SweeperMEMBER

    The IMF is coming out with some good stuff lately.
    There has to be a link between a bloated finance sector and secular stagnation. The link is probably through weak investment demand. Ie. Bloated out of control finance > greater chance of future shocks and more damaging shocks > expected cash flows become more risky > excessive discounting > weak investment. That would explain low risk free rates combined with weak investment. Look at non-residential investment in the US post the NASDAQ bubble – it never recovered. That is what Australia has to look forward to once our twin mining and housing bubbles are over. At some point someone will probably come out with a study showing that a bloated finance sector shaves off x% from the growth rate. Allan Greenspan could not have been more wrong.

  5. As an engineer, traditionally we used to say that those that went into management and marketing had crossed over to the dark side these days it’s the engineers in finance that have crossed over and are definitely practitioners of the dark-arts.
    Personally, having recently converted from real world product engineering to financial engineering I sometimes feel guilty that I have betrayed my roots. The feeling does not sit easily but fortunately the money is so good that I can simply drown my sorrows in top shelf plonk.
    Not sure what it all means, but there is definitely something wrong with a world where Engineers are rewarded better for destroying productivity than creating it, In my more somber moments I wonder if this curious situation (rewarding the counter productive) is not simply the logical way for a narcissistic society to destroy itself.

    Anyway that’s enough soul searching, there’s money to be mined!

  6. The Eurozone Troika have been busy over the last seven odd years joining the dots so I suppose it was only a matter of time before the revelations were assembled into a good old read. It’s an irritation that we have to suffer these freaking bell curves when they let the tea ladies loose, but more so a sad reflection on the profession when I can’t pronounce the names of people on the cover. It’s a pretty document all the same and FOC so worth having a look at albeit enjoying life in the rear vision mirror.
    Unfortunately, having been unable to move past the executive summary without reconstituting my breakfast it’s in the turn up file until I can unwind the MNE mystery in the budget.

  7. There is absolutely no reason for the Finance Industry to be so important that it can’t be let go. The Finance Industry is full of shit & has been for a very long time. There are no ethics, there is no moral compass, there is not many reasons why they can’t be Nationalised. Right now they are Rent seeking blood sucking low life! Paid enormous amounts of money simply because they are brilliant at obfuscation, churning & burning. They do nothing else other than act as one enormous great Building Society. No reason for them to be Special….add zero value..