By Central Bank News
If credit and finance helps businesses grow, it follows that a country should encourage a vibrant and large financial sector. That, at least, was the logic behind the wave of financial deregulation that swept through advanced economies in the 1990s.
But with the repercussions of the 2008 financial crises still reverberating, economists are starting to question that belief with some concluding that finance can indeed become excessive and this has a negative effect on growth.
The latest contribution to this debate comes from the Bank for International Settlements (BIS), with a working paper that concludes that at low levels, such as in developing economies, a large financial system can spur faster growth in 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,” wrote BIS chief economist Stephen Cecchetti, and BIS staff economist Enisse Kharroubi in “Reassessing the impact of finance on growth.”
The financial sector becomes a drag on growth when private credit exceeds a country’s total output or when more than 3.5 percent of workers are employed in the financial sector, the paper finds. Close to 5 percent of all workers were estimated to have been employed in the U.S. financial sector prior to the financial crises.
The paper also finds that faster growth in finance is bad for overall growth, a finding that leads the authors to conclude that financial booms are inherently bad for a nation’s trend growth.
The authors admit that at first, the conclusions are surprising. However, after closer scrutiny, they realize the consequences of financial booms mirror the dotcom boom of the 1990s when investors threw money at internet start-ups.
“It is only when they crash, after the bust, that we realise the extent of the overinvestment that occurred. Too many companies were formed, with too much capital invested and too many people employed. Importantly, after the fact, we can see that many of these resources should have gone elsewhere,” the paper said.
The theme of an excessive finance was also explored in the recent IMF paper “Too Much Finance?” which also suggested that finance starts having a negative effect on growth when credit to the private sector reaches 100 percent of GDP.
The understanding that a financial sector can become excessive is not only important for advanced economies but also for emerging economies that are trying to develop their own financial industry and markets.
“In their quest for optimal financialisation, the countries that are attempting further deregulation and development of financial markets would benefit from an understanding of how excess financialisation manifests itself,” said Y.V. Reddy, former governor of the Reserve Bank of India, in last month’s Per Jacobsson lecture in Basel, Switzerland.
The experience of advanced economies may thus help developing economies avoid the negative consequences of an excessively large financial sector.
“Research has associated higher growth with the development of the financial sector, but more recent evidence on trade-offs between growth in the real sector and the financial sector is equivocal,” Reddy said.
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