How A Bloated Wall Street Can Hurt Growth
We all know an out-of-control financial sector can cause acute and long-lasting problems, thanks to the recent financial crisis. But is there also a more chronic drag on the economy when the finance crowd gets too thick?
One recent paper (PDF) suggests so, and tries to quantify just how much a bloated financial sector can hurt economic growth.
The authors aren't your typical iconoclasts: Stephen G Cecchetti and Enisse Kharroubi work for the Bank for International Settlements, which serves as a kind of working group for central banks around the world.
The paper's conclusion is, in effect, that a well developed financial sector is good for growth — but that too much of a good thing isn't so good in the end, and hurts some industries more than others.
To quote the paper's introduction:
"... at low levels, a larger financial system goes hand in hand with higher productivity growth. But there comes a point – one that many advanced economies passed long ago – where more banking and more credit lower growth."
The authors go on to conclude that rapid growth in the financial sector slows real growth. In other words: All else equal, a boom-and-bust financial sector grows more slowly over the long term than the slow-and steady variety.
And what part of the economy suffers the most? Industries that depend heavily on research and development — the very high-tech industries on which many cities, states and countries are pinning their hopes.
This happens because the financial industry can lure the best and brightest from elsewhere, the authors write.
"It requires not only physical capital, in the form of buildings, computers and the like, but highly skilled workers as well. Finance literally bids rocket scientists away from the satellite industry. The result is that erstwhile scientists, people who in another age dreamt of curing cancer or flying to Mars, today dream of becoming hedge fund managers."
Of course, even in a high-finance society, plenty of people continue to dream of (and work toward) curing cancer and flying to Mars. But if, at the margins, smart and capable people go into finance instead, it can make a difference.
Isn't all economic growth more or less the same? Not necessarily. Finance is like trucking: Both facilitate other business. Having too-small a trucking sector is bad, because goods don't get to market. But a sprawling and inefficient trucking industry could be bad as well, driving up the cost of getting goods to market and absorbing time, energy and resources that customers could otherwise put into innovation.
The authors pinpoint some fairly straightforward benchmarks: Overall, "when private credit grows to the point where it exceeds GDP, it becomes a drag on productivity growth." And they estimate that a boom in the financial sector lowers economic growth per worker by an estimated 0.5 percent, when compared to a country with stable employment in the financial sector.
In countries where the financial sector is growing rapidly relative to the rest of the economy, the authors say R&D-intensive industries could see productivity growth "something like 2 percentage points per year less" than an industry less dependent on R&D and in a country with a slower-growing financial sector.
We aren't the first to notice this study. It came to our attention by way of Dean Baker, a progressive economist and co-director of the Center for Economic and Policy Research. In a blog post he wrote late last month, he generally praised the paper, but raised some potential criticisms as well. For example, he noted that the study's results could be skewed slightly by ending in 2008, when "productivity growth ... largely reflects how quickly firms could dump workers in response to the downturn."
The Alphaville blog, over at the Financial Times, also spotted the study, and found the faintest of silver linings:
"The next time you are feeling glum about impact of the global financial crisis, perhaps think of this... maybe the scientists who flocked to banks and hedge funds will start doing research again. Maybe we have more breakthroughs to look forward to as a result of the retrenchment of resources."