Finance drives growth, but too much of a good thing sucks the lifeblood, brains and brilliant ideas from an economy, according to “startling” findings at the Bank for International Settlements.
And advanced economies are overweight and even obese with financial services.
“Finance, literally bids rocket scientists away from the satellite industry,” BIS economists warned, saying that it competes for people with high qualifications as well as for buildings and equipment. “The result is that 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.”
So argue BIS economists Stephen Cecchetti and Enisse Kharroubi, who offer deep insights into one aspect of the financial and debt crisis which has hit rich countries in the last four years.
Referring to the dotcom boom of the 1990s and countless other boom-and-bust experiences, they said: “Booming industries draw in resources at a phenomenal rate. It is only when they crash, after the bust, that we realize the extent of the overinvestment that occurred.”
Beginning with the premise of economic theory that “finance is good for growth,” they noted that this had been one driver of financial deregulation.
The argument was that “if finance is good for growth, shouldn’t we be working to eliminate barriers to further financial development?”
The economists then set themselves a question: Is this true regardless of the size and growth of the financial sector?
“Or, like a person who eats too much, does a bloated financial system become a drag on the rest of the economy?” they asked.
For an answer they said: “We present two very striking conclusions.”
First, “with finance you can have too much of a good thing,” they said. “At low levels, an increase in the size of the financial sector accelerates growth of productivity.”
However, “there comes a point — one that many advanced economies passed long ago — where more banking and more credit are associated with lower growth.”
Their analysis showed that when private credit grew to a point greater than GDP, “it becomes a drag on productivity growth.”
Also, when the financial sector accounted for more than 3.5 percent of total employment, further development of finance tended to damage economic growth.
The two economists, writing in a personal capacity, have even come up with a cut-off or turning point at which the size of the financial sector does more harm than good: when the number of people in finance exceeds 3.9 percent of all people in employment.
Examples of countries beyond this “growth-maximizing point” are Canada (with about 5.5 percent), Switzerland (5.1 percent), Ireland (4.6 percent) and “to a lesser extent” the US (about 4.2 percent).
However, the economists, whose work was distributed recently by the BIS as a matter of “topical interest,” warn that the negative effect on growth may hit the economy sooner. Their table put this lower turning point at about 1.3 percent of total employment.
In that case “all countries in our sample are considerably above” the lower band for the turning point.
The sample used for analysis at the BIS, the so-called central bankers’ central bank, comprises 21 countries: Australia, Austria, Belgium, Britain, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, South Korea, Spain, Sweden, Switzerland and the US.