Has the financial sector become too large, absorbing too many resources, and enhancing instabilities? A look at the recent evidence on the relationship between the size of the financial sector and growth.
There has been a long history of the idea that a developing financial sector (emphasis on banks and stock markets) fosters economic growth. Going back to the work of authors such as Schumpeter, Robinson, and more recently, McKinnon, etc., there have been debates on financial liberalisation and the related issue of whether what was relevant to financial liberalisation, namely financial development, “caused” economic development, or whether economic development led to a greater demand for financial services and thereby financial development.
The general thrust of the empirical evidence collected over a number of decades suggested that there was indeed a positive relationship between the size and scale of the financial sector (often measured by the size of the banking system as reflected in ratio of bank deposits to GDP, and the size of the stock market capitalisation) and the pace of economic growth. Indeed, there have been discussion on whether the banking sector or the stock market capitalisation is a more influential factor on economic growth. The empirical evidence drew on time series, cross section, and panel econometric investigations. To even briefly summarise the empirical evidence on all these aspects is not possible here. In addition, the question of the direction of causation still remains an unresolved issue.
The processes of financialisation over the past few decades have involved the growing economic, political and social importance of the financial sector. In size terms, the financial sector has generally grown rapidly in most countries, whether viewed in terms of the size of bank deposits, stock market valuations, or more significantly in the growth of financial products, securitisation, and derivatives as well as trading volume in them. This growth of the financial sector uses resources, often of highly trained personnel, and inevitably raises the question of whether those resources are being put to good use. This is well summarised by Vanguard Group founder John Bogle, who suggests, “The job of finance is to provide capital to companies. We do it to the tune of $250 billion a year in IPOs and secondary offerings. What else do we do? We encourage investors to trade about $32 trillion a year. So the way I calculate it, 99% of what we do in this industry is people trading with one another, with a gain only to the middleman. It’s a waste of resources” (MarketWatch, Aug. 1 2015).
Financial liberalisation and de-regulation were promoted as ways of releasing the power of the financial sector, promoting development of financial markets and financial deepening. The claims were often made by the mainstream that financial liberalisation had removed “financial repression” and stimulated growth. Yet, financial liberalisation in a country often led to banking and financial crises, many times with devastating effects on employment and living standards. Financial crises have become much more frequent since the 1970s in comparison with the “golden age” of the 1950s and 1960s. The international financial crisis of 2007/2008 and the subsequent Great Recession were the recent and spectacular crises (though the scale of previous crises such as the East Asian ones of 1997 should not be overlooked). The larger scale of the financial sector in the industrialised countries has been accompanied (even before 2007) with somewhat lower growth than hitherto. As the quote above suggests there has not been an upsurge of savings and investment, and indeed many would suggest that the processes of financialisation dampen the pressures to invest, particularly in research and development. Has the financial sector become too large, absorbing too many resources, and enhancing instabilities?
An interesting recent development has been a spate of research papers coming from international organisations and many others, which have pointed in the direction that indeed the financial sector in industrialised countries have become too big—at least when viewed in terms of its impact on economic growth. (See Sawyer, “Financialisation, financial structures, economic performance and employment,” FESSUD Working Paper Series No. 93, for a broad survey on finance and economic performance.) These studies rely on econometric (time series) estimation and hence cover the past few decades—which suggests that their findings are not in any way generated by the financial crisis of 2007/2008 and the Great Recession that followed.
A Bank of International Settlements study concluded that “the complex real effects of financial development and come to two important conclusions. First, financial sector size has an inverted U-shaped effect on productivity growth. That is, there comes a point where further enlargement of the financial system can reduce real growth. Second, financial sector growth is found to be a drag on productivity growth.” Cournède, Denk,and Hoeller (2015) state that “finance is a vital ingredient for economic growth, but there can also be too much of it.” Sahay, et al. (2015) find a positive relationship between financial development (as measured by their “comprehensive index”) and growth, but “the marginal returns to growth from further financial development diminish at high levels of financial development―that is, there is a significant, bell-shaped, relationship between financial development and growth. A similar non-linear relationship arises for economic stability. The effects of financial development on growth and stability show that there are tradeoffs, since at some point the costs outweigh the benefits.”
There are many reasons for thinking that the financial sector has become too large. Its growth in recent decades has not been associated with facilitating savings and encouraging investment. It has absorbed valuable resources which are largely engaged in the trading in casino-like activities. The lax systems of regulation have made financial crises more likely. Indeed, and following the international financial crisis of 2007/2008 and the great recession a number of proposals have been put forward to avoid similar crises. To this day, nonetheless, the implementation of these proposals is very slow indeed (see, also, Arestis, “Main and Contributory Causes of the Recent Financial Crisis and Economic Policy Implications,” for more details).
Arestis, P. (2016), “Main and Contributory Causes of the Recent Financial Crisis and Economic Policy Implications,” in P. Arestis and M. C. Sawyer (eds.), Emerging Economies During and After the Great Recession, Annual Edition of International Papers in Political Economy, Houndmills, Basingstoke: Palgrave Macmillan, 2016, Forthcoming).
Cecchetti, S.G. and Kharroubi, E. (2012), “Reassessing the impact of finance on growth,” BIS Working Papers, No 381.
Cournède, B., Denk, O., and P. Hoeller (2015), “Finance and Inclusive Growth,” OECD Economic Policy Papers.
Sahay, R. et al. (2015), “Rethinking Financial Deepening: Stability and Growth in Emerging Markets,” IMF Staff Discussion Note, SDN15/08.
Sawyer, M. (2015), “Financialisation, financial structures, economic performance and employment,” FESSUD Working Paper Series No. 93, February 2015 (available at fessud.eu).