Finance drives growth, but too much of a good thing sucksthe lifeblood, brains and brilliant ideas from an economy, according to“startling” findings at the Bank for International Settlements.
And advanced economies are overweight and even obese withfinancial services.
“Finance, literally bids rocket scientists away from thesatellite industry,” BIS economists warned, saying that it competes for peoplewith 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 ofbecoming hedge fund managers.”
So argue BIS economists Stephen Cecchetti and EnisseKharroubi who offer deep insights into one aspect of the financial and debtcrisis which has hit rich countries in the last four years.
Referring to the dotcom boom of the 1990s and countlessother boom-and-bust experiences, they said: “Booming industries draw inresources at a phenomenal rate.”
“It is only when they crash, after the bust, that we realisethe extent of the overinvestment that occurred.”
Beginning with the premise of economic theory that “financeis good for growth”, they noted that this had been one driver of financialderegulation.
The argument was that “if finance is good for growth,shouldn’t we be working to eliminate barriers to further financialdevelopment?”
The economists then set themselves a question: is this trueregardless of the size and growth of the financial sector.
“Or, like a person who eats too much, does a bloatedfinancial system become a drag on the rest of the economy?”
For an answer they said: “We present two very strikingconclusions.”
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 sectoraccelerates growth of productivity.”
But “there comes a point -- one that many advanced economiespassed long ago -- where more banking and more credit are associated with lowergrowth.”
Their analysis showed that when private credit grew to apoint greater than gross domestic product, “it becomes a drag on productivitygrowth”.
Also, when the financial sector accounted for more than 3.5percent of total employment, further development of finance tended to damageeconomic growth.
“Extreme” examples of Ireland, Spain
The two economists, writing in a personal capacity, haveeven come up with a cut-off or turning point at which the size of the financialsector does more harm than good: when the number of people in finance exceeds3.9 percent of all people in employment.
Examples of countries beyond this “growth-maximising point”are Canada (with about 5.5 percent), Switzerland (5.1 percent), Ireland (4.6percent) and “to a lesser extent” the United States (about 4.2 percent).
However the economists, whose work was distributed recentlyby the BIS as a matter of "topical interest", warn that the negativeeffect on growth may hit the economy sooner. Their table put this lower turningpoint at about 1.3 percent of total employment.
In that case "all countries in our sample areconsiderably above" the lower band for the turning point.
The sample used for analysis at the BIS, the so-calledcentral bankers' central bank, comprises 21 countries:
Australia, Austria, Belgium, Britain, Canada, Denmark,Finland, France, Germany, Ireland, Italy, Japan, Netherlands, New Zealand,Norway, Portugal, South Korea, Spain, Sweden, Switzerland, and the UnitedStates.
The calculations showed, for example, that if the number ofpeople in finance in Canada were to fall back to the turning point, grossdomestic product per worker would rise by 1.3 percentage points. ForSwitzerland the gain would be 0.7 percentage points and for Ireland 0.2percentage points.
"The case of Ireland is interesting because over theperiod 1995-99, the Irish financial sector's share in total employment was 3.84percent -- very close to the growth-maximising value.
"But over the next 10 years, the share rose to morethan 5.0 percent."
If the share had been constant at 3.84 percent, the growthof output per worker could have been up to 0.4 percentage points higher overthe last 10 years.
The economists came up with a second "quitestriking" discovery: "The faster the financial sector grows, theslower the economy as a whole grows."
To demonstrate their findings, they gave the examples of the"extreme cases" Ireland and Spain.
"During the five years beginning in 2005, Irish andSpanish financial sector employment grew at an average rate of 4.1 percent and1.4 percent per year, while output per worker fell by 2.7 percent and 1.4percent, respectively.
"Our estimates imply that if financial sectoremployment had been constant in these two countries, it would have shaved 1.4percentage points from the decline in Ireland and 0.6 percentage points inSpain.
"In other words, by our reckoning financial sectorgrowth accounts for one third of the decline in Irish output per worker and 40percent of the drop in Spanish output per worker."
They said: "Overall the lesson is that big andfast-growing financial sectors can be very costly for the rest of theeconomy."
The report was written against a background of some evidencethat finance has lost its shine for people going to university, and for thoseemerging as graduates, in advanced economies.
At the height of the pre-crises boom in financial services,the sector was sucking in many people with high skills in mathematics andfinancial engineering, known as "quants", for astronomical salaries.
