Can too much finance kill growth?

Nearly six years on from the greatest economic crisis since the Great Depression, the financial sector still isn’t off the hook. Yes, regulatory reform has been undertaken, from Dodd Frank to Basel III, but, for many, finance remains too big for its britches.

Take banking institutions, for example. In the United States, only 26% of Americans had “a great deal” or “quite a lot” of confidence in banks, according
to a 2014 Gallup poll, down from a pre-recession level of 41%. Things are hardly better across the pond, where the 2014 British Social Attitudes Survey showed that only 34% of Britons felt that banks were well run; in 1983, that number stood at 90%.

If finance is still publicly tolerated and given relatively wide regulatory leeway, though, it is because financial services are generally understood to be integral to economic stability and growth. Nowhere is this clearer than in the UK, where TheCityUK, a British financial lobby, claims financial and related professional services employ 7% of the country’s workforce and produce almost 12% of total economic output.

Taking a more macro view, however, a recent paper from the IMF entitled Rethinking Financial Deepening: Stability and Growth in Emerging Markets questions just how straightforward the link between finance and economic growth and stability really is, especially in Advanced Economies. The central thesis of the paper is that, while the benefits of a developed financial system are evident, the 2008 crisis, among other events, has shown us that there are tradeoffs when finance is so deeply embedded in a country’s economy.  The crucial question then becomes: what is the optimum level of financial depth, and are we past it?

Risk-sharing vs. risk-taking

Theoretically, finance should have a positive causal relationship to both growth and stability. Finance facilitates the productive allocation of capital, improves monitoring and control over investments, enhances the trade of goods and services, and mutualises risk. In other words, finance shines a light into markets, improving the quality of information surrounding investments and, in turn, bringing in more investors and more capital. These two factors, better information and more players to share risk across, should make markets more efficient and more stable.

As any casual economic observer will know, however, the exact opposite occurred in the United States six years ago. Gross informational asymmetries meant that toxic sup-prime loans were swallowed by unwitting investors and the wide mutualisation of sup-prime risk only meant that the entire economy nearly collapsed. Finance was the problem, not the solution.

According to the IMF, this is because, at a certain point of development, finance becomes harmful both to stability and growth. From a sample of 128 countries from 1980-2013, financial development was seen to initially lead to an increase in growth and stability before the trend weakened and, eventually, turned negative. Financial development (FD) thus forms a bell curve on which the IMF tentatively places a sample of countries (see Figures 7 and 10). The shaded area between 0.45 and 0.7 (the latter is referred to as “the turning point”) on the FD index is thus the developmental sweet spot capable of generating “the largest cumulative growth returns”.

Graph1

The reasons the IMF offers for the negative impact financial development, or “deepening”, has on growth and stability are twofold. First, financial development continually attracts highly qualified human capital in a ‘brain drain’ away from other, more productive sectors. As a case in point, nearly 50% of Harvard seniors flocked to Wall Street in 2007, right before the crisis.

Graph2

Second, as many have pointed out ex post facto, a heavily entrenched financial sector can be susceptible to moral hazard and excessively risky behaviour. For the IMF, high financial development combined with loose regulation can promote “greater risk-taking and leverage”, leading to a consequent increase “financial volatility and the probability of a crisis”.

What do we do?

So, if one accepts the IMF’s findings that, beyond a certain point, financial development actually harms economic growth and stability, what can be done? Martin Wolf, associate editor and chief economics commentator at the Financial Times, sees three broad steps that should be taken in response to the IMF and other data.

First, Wolf argues, the moral paradigm of finance needs to change. While there is undoubtedly a greater need to police finance, with its “conflicts of interest and asymmetric information” (one could perhaps add the ‘revolving door’ between the financial sector and the governmental institutions meant to supervise it), such policing would simply be too costly and complex to carry out. Those working in the financial services industry thus need to hold themselves to a higher moral standard.

It is difficult, of course, to imagine any major paradigm change, while the material benefits of illegal, or at least immoral, behaviour in finance are so profitable. Enter Wolf’s second suggestion: tackling the incentive. The most immediate and effective policy change would be ending the tax deductibility of interest. Thirdly, Wolf argues that a “too big to fail” status and the moral hazard this can entail must be dealt with, chiefly through raising equity capital requirements for “global systemically important financial institutions”.

To sum it all up, again using Wolf’s words: “What is needed is not more finance, but better finance. Yes, this might also end up as substantially less finance.”

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