Bank of England Governor Mark Carney surprised his audience at a conference late last year by speculating that banking assets in London could grow to more than nine times Britain’s GDP by 2050. His forecast represented a simple extrapolation of two trends — continued financial deepening worldwide and faster growth of financial assets than of the real economy, and London’s maintenance of its share of global financial business.
These may be reasonable assumptions, but the estimate was deeply unsettling to many. Hosting a huge financial center, with outsized domestic banks, can be costly to taxpayers. In Iceland and Ireland, banks outgrew their governments’ ability to support them when needed. The result was disastrous.
Quite apart from the potential bailout costs, some argue that financial hypertrophy harms the real economy by syphoning off talent and resources that could better be deployed elsewhere. Carney says that, on the contrary, the rest of the British economy benefits from having a global financial center in its midst.
“Being at the heart of the global financial system broadens the investment opportunities for the institutions that look after British savings, and reinforces the ability of UK manufacturing and creative industries to compete globally,” he said.
That is certainly the assumption on which the London market has been built and the line that successive UK governments have peddled, but it is coming under fire.
Andy Haldane, one of the lieutenants Carney inherited at the central bank, has questioned the financial sector’s economic contribution, pointing to “its ability to both invigorate and incapacitate large parts of the non-financial economy.”
He said in a speech revealingly entitled “The Contribution of the Financial Sector: Miracle or Mirage?” that the financial sector’s reported contribution to GDP has been significantly overrated.
Two recent papers raise further doubts. In The Growth of Modern Finance, Robin Greenwood and David Scharfstein of Harvard Business School said that the share of finance in US GDP almost doubled between 1980 and 2006, just before the onset of the financial crisis, from 4.9 to 8.3 percent. The two main factors driving that increase were the expansion of credit and the rapid rise in resources devoted to asset management (associated, not coincidentally, with the exponential growth in financial-sector incomes).
Greenwood and Scharfstein said that increased financialization was a mixed blessing. There may have been more savings opportunities for households and more diverse funding sources for firms, but the added value of asset-management activity was illusory. Much of it involved costly churning of portfolios, while increased leverage implied fragility for the financial system as a whole and imposed severe social costs as over-exposed households subsequently went bankrupt.
Stephen Cecchetti and Enisse Kharroubi of the Bank for International Settlements — the central banks’ central bank — go further. They argue that rapid financial-sector growth reduces productivity growth in other sectors.
Using a sample of 20 developed countries, they find a negative correlation between the financial sector’s share of GDP and the health of the real economy.
The reasons for this relationship are not easy to establish definitively and the authors’ conclusions are controversial. However, it is clear that financial firms compete with others for resources, especially for skilled labor.