Financial industry may impede GDPFinance drives growth, but too much of a good thing can suck the lifeblood, brains and brilliant ideas from an economy, according to “startling” findings at the Bank for International Settlements.
It added that most advanced economies are bloated due to having too many financial services.
“Finance literally bids rocket scientists away from the satellite industry,” BIS economists warned, saying that the financial industry 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 that has pummeled wealthy countries in the last four years.
“Booming industries draw in resources at a phenomenal rate,” they said, referring to the dotcom boom of the 1990s and countless other boom-and-bust experiences. “It is only when they crash, after the bust, that we realize the extent of the overinvestment that occurred.”
Beginning with the theoretical premise that “finance is good for growth,” they noted that this had been one driver of financial deregulation. “If finance is good for growth, shouldn’t we be working to eliminate barriers to further financial development?” they argued.
The economists then asked whether this was 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?”
In answer, they offered two 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.” But “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 grows to a point greater than gross domestic product, “it becomes a drag on productivity growth.”
And when the financial sector accounts for more than 3.5 percent of total employment, further development of the industry tends to damage economic growth, they added.
The two economists also came up with a tipping point, declaring that when the number of people in the financial industry exceeds 3.9 percent of all those employed in the country, the sector starts to do more harm than good.
Examples of countries beyond this “growth-maximizing point” are Canada (5.5 percent), Switzerland (5.1 percent), Ireland (4.6 percent) and “to a lesser extent” the United States (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 even 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, they said.
The sample used for analysis at the BIS, the so-called central bankers’ central bank, comprises 21 countries, including 15 European nations, the United States, Australia, Canada, New Zealand, Korea and Japan.
The calculations showed that if the number of people in Canada’s financial industry were to shrink to the turning point, GDP per worker would rise by 1.3 percentage points. For Switzerland, the gain would be 0.7 percentage point, and for Ireland 0.2 percentage point.
“The case of Ireland is interesting because over the period 1995-99, the Irish financial sector’s share in total employment was 3.84 percent - very close to the growth-maximizing value,” they noted. “But over the next 10 years, the share rose to more than 5.0 percent.”
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 decade, according to their argument.
The economists came up with a second 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 two extreme cases, namely, Ireland and Spain. “Overall, the lesson is that big and fast-growing financial sectors can be very costly for the rest of the economy,” they said.