Is Finance a Drag on Economic Growth?

Later that year, John Kay, who founded a business school at Oxford University but is these days principally a writer, published his book Other People’s Money: Masters of the Universe of Servants of the People, dedicated to the same point Zingales made. It starts out by recounting, with increasing incredulity, the distorted numbers around the British banking sector – which is by no means the biggest. How is it, he wondered, that the £7 trillion of British banking assets is four times the aggregate annual income of everyone in the country? How is it that the value of daily foreign exchange transactions is nearly 100 times that of daily international trade in goods and services? How can it be that the value of assets underlying derivatives contracts is three times the value of all the physical assets in the world?

One reason for the apparently impossible mismatch is that banks don’t, in the main, spend their time doing what we think they are doing. “Lending to firms and individuals engaged in the production of goods and services – which most people would imagine was the principal business of a bank – amounts to about 3 per cent” of bank assets or liabilities in Britain, he says. Most bank assets are actually claims on other banks, and most bank liabilities are just obligations to the same banks. Banking today is chiefly a lot of electronic money going round in circles, serving no useful purpose in society.

It didn’t start out this way, and in younger financial systems, banking continues to have great value. “Modern societies need finance,” says Kay. When industrialization got started in places like Britain and the Netherlands, it did so at the same time as the development of finance, and the relationship is not coincidental.  The link can be proven by exception: in Communist states that suppressed financial systems such as (then) Czechoslovakia and East Germany, economies lagged.

The problem is, there are limits. “A country can be prosperous only if it has a well-functioning financial system,” writes Kay, “but that does not imply that the larger the financial system a country has, the more prosperous it is likely to be.

“Financial innovation was critical to the creation of an industrial society; it does not follow that every modern financial innovation contributes to economic growth. Many good ideas become bad ideas when pursued to excess.”

Indeed, the IMF – hardly a contrarian revolutionary when it comes to international finance – believes it has identified the point at which this transition from engine of growth to draining obstacle takes place. In May 2015 – 2015 was a pretty good year for doubting the value of finance – 12 IMF researchers published a report called Rethinking Financial Deepening: Stability and Growth in Emerging Markets. It set out with the premise of whether there was a point at which the benefits of financial development begin to decline and costs start to rise, and it tried to apply the question to emerging markets, studying 128 countries between 1980 and 2013.

The answer, it concluded, was between 0.4 and 0.7 on the financial development index, which recalls the answer to life, the universe and everything turning out to be 42: having deduced the answer, you then need another stab at working out what the question was in order to understand it. But to put it in practical terms, a country like Poland is in the sweet spot. Morocco is approaching it; Ireland has just left it; the USA and Japan have left it far behind. “Financial development increases growth,” the paper concluded, “but the effects weaken at higher levels of financial development, and eventually become negative,” in a bell-shaped curve. It also concluded that the pace of financial development matters – too fast and it becomes destabilising. “In other words, when it comes to financial deepening, there are speed limits.”

Others have tried similar calculations. Stephen Cecchetti, when head of the monetary and economic department at the Bank for International Settlements, came to similar conclusions to the IMF, calling finance “a two-edged sword” with a threshold beyond which it becomes a drag. In his view, this threshold is about debt: “productivity grows more slowly when a country’s government, corporate or household debt exceed 100% of GDP,” he wrote. He called the result, gleaned from studying 20 countries over 30 years, “unambiguous”. “There is a robust, economically meaningful, negative correlation between productivity and financial sector growth.”

Like the IMF, Cecchetti also looked to Ireland for evidence. Between 1995 and 2000, the ratio of Irish private payment to GDP ran at an average annual rate of 7.7%, then more than doubled to 16.9% between 2005 and 2010. Far from increasing productivity, this climb in debt impeded it, with a slowdown of 0.8 percentage points per year of productivity despite the doubling of credit. Spain shows a similar experience.

And Zingales puts the tipping point at the moment when credit to the private sector reaches 80-100% of GDP. One can even argue that lagged credit growth is a predictor of financial crises, and that financial stability risks increase with the size of the financial sector.

But what, specifically, is the burden finance brings when it gets too big? The IMF concluded there were three ways. One is that too much finance increases the frequency of booms and busts, leaving a country worse off in the aggregate and having suffered too much volatility along the way. Another is that it diverts talent away from productive sectors (and, indeed, from other vital services, from medicine to education). The third is that “a very large financial sector may be particularly susceptible to moral hazard or rent extraction from other sectors, both of which would lead to a misallocation of resources.” In other words, it’s not just that bankers are getting unfairly rich; it’s that it costs other sectors and society itself in order to enable that wealth.

Christine Lagarde, the head of the IMF, followed up on the IMF report in a speech last year. “When financial sector development outpaces the strength of the supervisory framework, there is excessive risk taking and instability,” she said. “The experience in many countries, including in the United States, has exposed the dangers of financial systems that have grown too big too fast.”

There’s also a question of how innovation really contributes to a society, and this has been brought into stark relief by the global financial crisis. Clearly, developments in the securitization market, chiefly around collateralized debt obligations, represented sophisticated brains at work but were not terribly conducive to the world economy when they brought it crashing down. “I am not aware of any evidence that the creation and growth of the junk bond market, the options and futures market, or the development of over-the-counter derivatives are positively correlated with economic growth,” said Zingales in his ABA address.

And this brings us back to the talent question. “Another important dimension is where innovation efforts take place,” said Zingales. “If the most profitable line of business is to dupe investors with complex financial products, competitive pressure will induce financial firms to innovate along that dimension, with a double loss to society: talents are wasted in search of better duping opportunities and the mistrust towards the financial sector increases.”

There is an increasing sense that society wants its banks to go back to basics, a wish that collides with shareholder requirements for greater returns, and banks’ thirst for greater profit. Key identifies four simple ways banking is meant to contribute to our society: the payments system, through which we receive wages and buy goods and services; matching lenders with borrowers, helping to direct savings to their most effective uses; helping us manage our personal finances through our lifetimes and between generations; and helping both individuals and businesses to manage risks associated with everyday life.

But where are the big bucks in that? Modern investment banks would smirk at the simplicity. The money, they will tell you, is in complex structured lending, in advisory fees for cross-border Chinese M&A, in cross-selling investment bank product to high net worth entrepreneurs, in prime brokerage to hedge funds. The days of hell-bent proprietary trading and CDO-squared may be gone for the moment, but other ideas come to take their place, and they are rarely simple.

So what is to be done? Perhaps in some sense the problem will prove to be self-fulfilling. If banks stop making profits in the same way they used to – and bank profitability is under major threat all over the world – then the brightest minds in the business may decide their bonuses are no longer so attractive and try their hands in other industries. “Finance is not special,” Key says, “and our willingness to accept uncritically the proposition that finance has a unique status has done much damage.”