NYT: How Overfinancialization Harms the Economy

New research shows that a fast growing banking sector can actually harm real growth by focusing investments on nonproductive industries rather then long-term innovative and manufacturing industries.

[Reposted from The New York Times  |  Gretchen Morgensen  |  February 28, 2015]

No, no and no, JPMorgan replied. “Scale has always defined the winner in banking,” said Marianne Lake, the company’s chief financial officer.

It is to be expected that all big bank executives believe in big finance. They benefit from being giant, after all.

For the rest of us, though, it’s worth noting that the effects of a dominant financial industry are far less beneficial.

Certainly, as we learned in 2008, when megabanks get into trouble, they line up for bailouts. This imperils taxpayers.

But even during good times the impact of big finance can be negative for the world at large. According to a compelling new paper published two weeks ago by the Bank for International Settlements, high-growth financial sectors actually hurt the broader economy by dragging down overall growth and curbing productivity.

The paper’s co-authors are Stephen G. Cecchetti, economics professor at Brandeis International Business School, and Enisse Kharroubi, senior economist at the B.I.S. Their findings are a great addition to the debate about how much is too much when it comes to the role finance should play in our economy.

The paper is titled “Why Does Financial Sector Growth Crowd Out Real Economic Growth?” and it builds on past research that found that overall productivity gains were dragged down in economies with rapidly growing financial industries.

This idea seems almost counterintuitive. Wouldn’t a booming finance industry mean that money is humming through all parts of the economy, financing growth in all kinds of industries? In the new paper, the authors looked for an answer. They studied 33 manufacturing industries in 15 advanced economies around the world.

They found that financial booms were especially harmful to certain industries. Bankers, they say, act in predictable ways. They tend to lend money to projects with assets that can be pledged as collateral, such as those in real estate or construction. This is understandable — bankers want to be able to seize assets if a borrower gets into trouble on a loan, and they prefer those assets to be tangible.

But these industries are also among the least productive, and that leaves fewer dollars for more promising research-and-development start-ups that may have only intangibles, such as knowledge and ideas, to offer a banker as collateral. Even though such start-ups have far more potential than projects backed by tangible collateral, they don’t attract the financing they need.

This is true during slow-growth economic times as well, but during boom times, so much money crowds into less productive sectors that the overall economy suffers.

“By draining resources from the real economy,” the authors wrote, “financial-sector growth becomes a drag on real growth.”

The impact is sizable.

“We find unambiguous evidence for very large effects of financial booms on industries that either have significant external financing needs or are R.&D.-intensive,” the authors concluded in their paper. Even in economies where finance is growing quickly, industries that require a lot of research and development trail the performance of other industries in economies where finance is experiencing slower growth, they found. In fact, that productivity growth appeared to be two percentage points lower per year. Two percentage points a year is an enormous difference.

Another pernicious element is at work, the authors said. When finance is ascendant in an economy, it attracts an inordinate number of highly skilled workers who might otherwise take their productivity and brains to nonfinancial industries.

I spoke with Professor Cecchetti last week about the paper. “When I was in college long ago, all my friends wanted to figure out how to cure cancer,” he said. “But by the 1990s, everyone wanted to become hedge fund managers. Do we want to have more hedge fund managers or more people trying to figure out how to solve our energy and environmental problems or otherwise improving our lives? That’s the way I think about the problem.”

There may be hope on that score. Some 31 percent of the Yale class of 2000 were employed in finance a year after graduation; among last year’s class, 17 percent went to work in the industry, according to a university survey.

Still, finance was the most popular pursuit among Yale graduates last year; the next industry down the list was education, with 11.9 percent.

Thomas Philippon, a finance professor at New York University’s Stern School of Business, is another academic who has studied the role of finance in the economy.

In a November 2012 article in The Quarterly Journal of Economics, Mr. Philippon and Ariell Reshef, an economist at the University of Virginia, reported on wages in the United States financial industry from 1909 to 2006. Among their findings: Finance accounted for 15 to 25 percent of the overall increase in wage inequality between 1980 and 2006.

Also questioning the dominance of finance in our society is Luigi Zingales, professor of entrepreneurship and finance at the University of Chicago Booth School of Business. In his 2012 book, “A Capitalism for the People,” he wrote that the financial sector, “thanks to its resources and cleverness, has increasingly been able to rig the rules to its own advantage.”

If big finance can have such injurious implications, what should policy makers do? “In some countries we see governments that are very protectionist of financial companies,” Professor Cecchetti said. “The two issues you want to worry about are what happens when there is too much debt and financing in your economy, and if you are subsidizing it, you might want to think about that pretty hard.”

One way we subsidize debt in this country is by providing tax deductions for mortgage interest. That policy encourages borrowers to take on bigger home loans than they otherwise might.

Even now, as the mortgage crisis recedes into the distance, it remains critical that we assess the financial industry’s purpose and try to determine whether it adds value in our society.

Ideally, finance should propel an economy by helping create jobs and wealth for a broad portion of the population. But clearly, there’s a point when finance sucks too much oxygen out of the room, leaving the rest of us gasping for air.

Bigger, in finance, it seems, is not better.


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