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.
The calculations showed, for example, that if the number of people in finance in Canada were to fall back to the turning point, GDP per worker would rise by 1.3 percentage points. For Switzerland the gain would be 0.7 percentage points and for Ireland 0.2 percentage points.
“The case of Ireland is interesting because over the period from 1995 to 1999, the Irish financial sector’s share in total employment was 3.84 percent — very close to the growth-maximizing value. But over the next 10 years, the share rose to more than 5 percent,” they said.
If the share had been constant at 3.84 percent, the growth of output per worker could have been up to 0.4 percentage points higher over the last 10 years.
The economists came up with a second “quite striking” discovery: “The faster the financial sector grows, the slower the economy as a whole grows.”
To demonstrate their findings, they gave the examples of the “extreme cases” Ireland and Spain.
“During the five years beginning in 2005, Irish and Spanish financial sector employment grew at an average rate of 4.1 percent and 1.4 percent per year, while output per worker fell by 2.7 percent and 1.4 percent, respectively,” they said.
“Our estimates imply that if financial sector employment had been constant in these two countries, it would have shaved 1.4 percentage points from the decline in Ireland and 0.6 percentage points in Spain,” they added.
“In other words, by our reckoning financial sector growth accounts for one third of the decline in Irish output per worker and 40 percent of the drop in Spanish output per worker,” they said.
They said: “Overall the lesson is that big and fast-growing financial sectors can be very costly for the rest of the economy.”
The report was written against a background of some evidence that finance has lost its shine for people going to university, and for those emerging as graduates, in advanced economies.
At the height of the pre-crises boom in financial services, the sector was sucking in many people with high skills in mathematics and financial engineering, known as “quants,” for astronomical salaries.