Why does financial sector growth crowd out real economic growth?

In writing about the role the financial sector plays in the UK economy, FT columnist Martin Wolf made the following observations:

Financial deepening does promote prosperity, but only up to a point. Many high-income countries are beyond it. The huge expansion in finance since 1980 has not brought commensurate economic gains. Many developing countries do have room to grow finance, to their benefit; India is an example. Yet some may already have enough. It is also far from clear that arguments for cross-border financial integration carry over from those for trade in goods. Financial integration carries with it risks of crises, as emerging countries have learnt. The costs of self-insurance against crises are steep. A desire to protect domestic financial stability, by insisting that foreign banks create subsidiaries, not branches, is wise. (emphasis added) (Wolf 2013)

Wolf cited a Bank of International Settlements paper, Why does financial sector growth crowd out real economic growth (Cecchetti et al. September 2013) which concluded:

First, the growth of a country’s financial system is a drag on productivity growth. That is, higher growth in the financial sector reduces real growth. In other words, financial booms are not, in general, growth enhancing, probably because the financial sector competes with the rest of the economy for resources.
Second, using sectoral data, we examine the distributional nature of this effect and find that credit booms harm what we normally think of as the engines for growth: those that are more R&D-intensive.
This evidence, together with recent experience during the financial crisis, leads us to conclude that there is a pressing need to reassess the relationship of finance and real growth in modern economic systems. (emphasis added)

after making four assertions based on the authors’ analysis of their data:

First, there is the possibility that the negative impact of financial growth on industry-level productivity growth arises from the level of financial development itself. If financial sector growth and the level of financial development are negatively related (larger financial sectors tend to grow more slowly) and the size of the financial sector is positively related to industry productivity growth, then we would mistakenly attribute to financial sector growth a negative effect that in reality reflects the positive effect of the financial development level. Second, we look at the impact of monetary policy. Financial sector growth is likely to be related to the stance of monetary policy and the cost of capital: the more accommodative monetary policy and the lower the cost of capital, the faster the financial sector will grow. Since monetary policy is most accommodative during periods when aggregate growth is low, this raises the possibility that what we are finding is essentially monetary policy acting counter-cyclically. Third, there is the potential impact of fiscal policy. If fiscal deficits crowd out private credit extension, then again we could be confounding an aggregate cyclical policy with what we believe to be a cross-sectional effect. Lastly, it may be important to control for the extent to which the economy is actually a net importer of both capital and goods, as this could influence the availability of resources and have a differential impact on the productivity performance of more financially constrained sectors. (emphasis added) (Cecchetti et al. September 2013)

The full paper can be read here.

These observations and conclusions dovetail on last week’s post Asset price collapses, banking crises and recessions (Werner 2005) which called out the banking sector for relying on high collateral/low productivity projects rather than contributing to a nation’s productive capacity. This is a generality but fits well in terms of how credit is created and expanded in modern economies. My colleague David Wishart (whose always insightful blog can be read here) commented that:

One avenue to encourage the good kind of productive bank lending is through modifications to the Basel III rules that specify the “risk weight” that loan assets receive. These risk weights define the charge against the bank’s capital that each loan consumes. Retail small business lending receives a 100% risk weight, which is high, whereas a government bond receives a 0% weight. So if productive loans could be given a very low risk weight so that they don’t hurt bank capital ratios while speculative non-productive loans were given a high risk weight, regulation could be used to guide the economy back towards a more productive stable footing and away from serial credit crunches and asset bubbles. (emphasis added)

Underlying such a proposal is understanding explicitly that the financial sector would be less profitable as risk would effectively shift towards it as it would be forced to underwrite loans for potentially productive purposes rather than for projects that are more speculative (but due to collateralization more secure) in nature. Loans for SMEs generally and start-up entrepreneurial ventures in particular are subject to greater risk and outright default –that is the point of capitalism– and as such remain an essential ingredient for dynamism within an ostensibly capitalist market based system. Doing so pays off in the long run as access to credit in today’s environment and scarcity of financial capital generally becomes the liquidity and solvency constraint on the long run feasibility of enterprise.

If the current paradigm cannot or will not be changed due to vested interests preferring the status quo then what are the alternatives? For one, there are calls from disparate parties to embrace concepts such as narrow banking, local banking, or a modern version of Henry Simons’ Chicago Plan which has been articulated recently by Jaromir Benes and Michael Kumhof in their working paper, The Chicago Plan Revisited. Of course, these alternatives are far from exhaustive as they do not cover other alternatives such as free banking or a return to a commodity standard.

Whether an alternative monetary system is embraced or the current system is tinkered with, there needs to be a reckoning with the concept of “money = debt” that underpins our economic system and drives commerce and the flow of capital globally.

Every working day the silent majority sit quietly at home, exhausted after a day of work and commuting –sometimes for hours– complacent with their reality that house prices are very high and increasingly unaffordable, wage growth stagnant, job security elusive, retirement prospects bleak and the social contract that had underpinned modern society withering. Expecting them to come to terms with the reality that some 67 years ago, taking the UK as an example, debt free money (e.g. cash, coins, aka “money = asset”) accounted for 46% of the money supply, while today it accounts for just 2.6% is bound to be met with cognitive dissonance. These truths are only now found in fading memories of a generation past. Yet, this phenomenon –more money as debt, less as an asset– is likely to continue without the spoils of one’s labour being rewarded as access to credit has been critical to maintaining consumption:

Between 2000 and 2006, the US economy expanded by 18 percent, whereas real income for the median working household dropped by 1.1 percent in real terms, or about $2,000… Meanwhile, the top tenth saw an improvement of 32 percent in their incomes, the top 1 percent a rise of 203 percent and the top 0.1 percent a gain of 425 percent. Part of this was because the latest period of economic growth failed to create jobs at nearly the same rate as in previous business cycles and even led to a decline in the number of hours worked for most employees. Unusually for a time of expansion, the number of participants in the labour force also fell. But mostly it was because the fruits of economic growth and soaring productivity rates went to the highest income earners. (emphasis added) (Luce 2008)

The fewer funds flowing to households generally, the greater reliance those households will have on credit to smooth consumption until they reach an inflection point of restricting consumption and deleveraging. The financial system is able to extend credit but in the long run it comes at the expense of the real economy. The lack of robustness and resilience we are witnessing in economies has been enabled and exacerbated by the governments that have signed off on the global and multi-lateral treaties that put no limits on the free flow of capital yet are inimical to the growth of a robust entrepreneurial nation state and the resulting jobs that potentially spring from it.

With a few exceptions like Luxembourg, nations cannot simply expect the financial sector to be largest employer: a portfolio of industries is better than over specialization. Yes, this is heretical to the concept of comparative advantage  Expecting a financial sector to grow without concomitant growth in the real sector is an invitation for the financial sector to cannibalize the hand that feeds it. The growth witnessed during the post Big Bang period till 2008 is giving way to a stagnant equilibrium punctuated by asset bubbles as capital looks for the best return irrespective of the externalities that result.


Wolf, Martin. “Carney places a bet on big finance.”Financial Times, Online edition, sec. Comment, October 29, 2013.

Cecchetti, Stephen G, and Enisse Kharroubi. Bank for International Settlements, “Why does financial sector growth crowd out real economic growth?.” Last modified September 2013. Accessed October 29, 2013. https://evbdn.eventbrite.com/s3-s3/eventlogos/67785745/cecchetti.pdf.

Benes, Jaromir, and Michael Kumhoff. IMF, “The Chicago Plan Revisited.” Last modified August 2012. Accessed October 30, 2013. http://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf.

Luce, Edward. “Stuck In The Middle”, Financial Times, sec. Comment, October 28, 2008


Japan Prime Minister Abe Says Japan Ready to Counter China’s Power – WSJ.com

Shinzo Abe makes headlines in the west for his reflationist economic policies (“Abenomics”) but he is not a true believer in that regard. He is, however, a believer in a more muscular, assertive, and militaristic Japan.

CHINDIA ALERT: You'll be living in their world, very soon

Japanese Prime MinisterShinzo Abe said he envisions a resurgent Japan taking a more assertive leadership role in Asia to counter China\’s power, seeking to place Tokyo at the helm of countries in the region nervous about Beijing\’s military buildup amid fears of an American pullback.

In an exclusive, wide-ranging interview with The Wall Street Journal, Mr. Abe also defended his program of economic reforms against growing criticism that the package lacks substance—though he offered few details of new programs, or a timetable, that anxious foreign investors have been seeking.

\”I\’ve realized that Japan is expected to exert leadership not just on the economic front, but also in the field of security in the Asia-Pacific,\” Mr. Abe said, referring to his meetings with the region\’s leaders at a series of summits this month.

In his continuing attempt to juggle his desire to enact economic-stimulus policies with the…

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Asset price collapses, banking crises and recessions (Werner 2005)

Instances of asset inflation are not welfare optimal. For one thing, it cannot be considered efficient nor equitable when new claims on finite resources are created by banks and then granted to a specific group of individuals who use them purely for speculative gain, without adding to productivity or output. Moreover, the extension of speculative loans and asset-collateralizing loans creates negative externalities in the economy and thus directly affects others. If house prices are driven so high that they are beyond the reach of first-time buyers, this can affect the quality of life of entire communities. In England, many cities are unable to attract sufficient numbers of welfare workers, teachers or firemen, as they cannot afford to live in them on their salaries. High real estate prices in city centres may increase commuting times and hence shorten the time available for family or leisure.

The externalities in the banking system are also significant: as banks become overextended to borrowers who have not invested the newly created money productively, our theory of productive credit creation tells us that, in aggregate, such loans cannot be paid back (only ‘productive’ loans will be non-inflationary and only ‘productive’ loans will produce goods and services of value, thus producing income to service the loans). As a result, systemic risk increases.

Bank lending for speculative purposes CF is only viable as long as banks continue to increase such lending. It seems a reasonable assumption that banks will not continue to increase their speculative lending CF into eternity. We thus consider what happens when at some stage (perhaps again induced by a regulatory shock, such as a change in the monetary policy of the central bank) CF  falls. According to equation (5), asset prices will fall. This will then reduce collateral values and bankrupt the first group of speculative borrowers who were seeking merely capital gains. Their default will create bad debts in the banking system. This in turn will raise banks’ risk aversion and reduce the amount of credit newly extended. This further reduces asset prices (equation 5), which increases bankruptcies. The process can easily make banks so risk averse that they also reduce lending to firms for productive purposes, in which case GDP growth will also fall (equation 4). Such credit crunches have been observed in many cases, including the US.[2] This exacerbates the vicious cycle, since with less economic growth, corporate sales and profits decline. As more firms become unstable, bad debts increase further (see Figure 16.1). [emphasis added] (Werner 2005)



Richard A. Werner, New Paradigm in Macroeconomics: Solving the Riddle of Japanese Macroeconomic Performance, (Houndmills, Basingstoke, Hampshire: Palgrave Macmillan, 2005), 229-230.


[2] For empirical evidence of the credit crunch problem in Japan see, for instance, Matsui (1996). On the US see, for instance, Gertler and Gilchrist (1994).

If Income has not recovered will the ‘recovery’ recover?

Jeff Rosenberg of BlackRock writes in their October Fixed Income Market Strategy :

Figure 3 highlights the longer term measurement of median family income from the census bureau updated to the end of 2012. Incomes have continued to fall since the onset of the crisis. Figure 3 also highlights the latest figures on income growth from the monthly employment situation report. This captures monthly wage trends and similarly highlights the collapse in income growth following the crisis.

That lack of income growing faster than prices are going up holds back consumers ability to spend.

[emphasis added]


Rosenberg’s point of income as a key to growth –I won’t refer to it as sustainable growth– hints that the United States recovery is demand constrained. Stagnant income absent access to credit entails depressed consumption as those in the upper percentile have little reason to spend hence no flow of funds trickling down. In addition, in the case of the masses one has to believe that in a cycle of household deleveraging and bank balance sheet repair that access to credit will not return unless it is extended by banks and non bank financials to the same households that embraced it over the past generation in order to maintain consumption –conspicuous or otherwise. Think of the analogy of banks: they can survive for a long time if they are insolvent but will dissolve if illiquid hence the emphasis on liquidity coverage ratios (LCR) in the Basel III framework. This analogy holds true for households.

There is a paper written by Perry Mehrling and published in 2000 titled Minsky and Modern Finance: The case of Long Term Capital management in which the Bernard College professor writes about Minsky’s prescient insights about the world we live in today long before that world existed based solely on the nascent financial society pre Fischer Black et al:

When Minsky wrote that capitalism is essentially a financial system, it was before the advent of modern finance, before financial deregulation and the mutual fund revolution, before the breakdown of Bretton Woods and the subsequent rise of global currency markets, before the Eurodollar market, before junk bonds, and before securitization. He was writing, in fact, before practically all the developments that have rendered his statement merely a truism now at the end of the twentieth century, which is not to suggest that he ahead to what would happen, since he didn’t. When he wrote that capitalism is essentially a financial system, he was referring to the capitalism of his own time, a capitalism that, by modern standards, was remarkably undeveloped financially. What then does he mean by “essentially financial”?[1]

Minsky means that in a capitalist economy every economic unit — every firm, household, government, even every nation — is, in essential respects, like a bank facing the problem of daily balancing cash inflow against cash outflow. For him, the key problem an economic unit faces is not the familiar economists’s problem of maximizing profit or utility subject to a budget constraint. More fundamental is the problem posed by the “survival constraint” that requires that cash outflow not exceed cash inflow.

To meet this constraint minute by minute, day by day, week in and week out, requires individual agents continually to have in mind the balance between their cash commitments and their cash flows, but it requires more than that. Because cash flows inevitably fall short from time to time, individuals require access to a reliable source of refinance that allows them to meet current cash flow needs by pledging expected future cash flows.

[emphasis added]

To read Mehrling’s full paper go here. The takeaway entails a lack of economic stability and growth; my personal bias also sees the underlying fault line in our economic system entailing a lack of resilience. We are a long way from Adam Smith’s ideal of perfect competition under conditions of perfect liberty; that world does not exist.


[1] For a fuller treatment of Minsky’s theories in the context of his life and time, see Mehrling [1999]. For an account of the broader American tradition of monetary thought to which Minsky belongs, see Mehrling [1997]

For the interested reader

Mehrling [1999] is “The Vision of Hyman P. Minsky.” Journal of Econoic Behavior and Organization, 39 (1999), pp. 129-158

Mehrling [1997] is The Money Interest and the Public Interest: American Monetary Thought, 1920-1970. Cambridge: Harvard University Press, 1997.


Rosenberg, Jeff. BlackRock, “Fool Me Once.” Last modified October 03, 2013. Accessed October 24, 2013. https://www2.blackrock.com/us/financial-professionals/market-insight/fixed-income-monthly.

Perry Mehrling, “Minsky and Modern Finance: The case of Long Term Capital Management,” The Journal of Portfolio Management, 26, no. 2 (2000): (81-88), http://economics.barnard.edu/sites/default/files/inline/minsky_and_modern_finance.pdf (accessed October 24, 2013).

Most Chinese growing old before China grows rich

I am not referring to the elites in the politburo of the CPC, the princelings, or those closely associated with the channels of power in the central kingdom. I am referring to the teeming masses who make the goods and provide the services that have made the aforementioned groups wealthy and powerful. For them, retirement isn’t what they expected it to be; the vast majority will grow old before their country grows rich enough to escape the middle-income trap and provide them the pension that they deserve after a life of toil and hardship.

In his always informative blog, chindia-alert.org, Chiahou Zhang (Charles Chang) links to yesterday’s Bloomberg Businessweek piece: Forget About Retiring, China’s economic Planners Say.

In it Dexter Roberts writes:

What if Chinese were required to work an extra five years, or even a decade, before retirement? There are growing calls among officials and academics in China to consider that controversial move as the country’s rapidly aging population puts new stress on its pension program. China must consider “deferred retirement,” said Hu Xiaoyi, a vice minister of human resources and social security, on Oct. 22, speaking to journalists at a seminar in Beijing.

This won’t be made easier if one considers that current projections of Chinese population aged 15 to 24 (based on the nations’ current one child policy staying in place) sees a drop off in that cohort as well as the working age population.



As I have stated previously (China won’t save the world) there are limits to China’s investment driven growth model although the amount of foreign exchange reserves and the surplus current account position permits the mandarins to pull the levers of fiscal stimulus again in order to spur growth.

Chinese GDP Growth Rate

Chinese GDP Growth Rate

But as Roberts hints the transition from being investment driven to consumption driven is not easy:

Meanwhile, as part of its desire to shift to a more consumption-driven economy, China is pushing an expansion of social welfare programs, expected to get a further boost at the upcoming Party Plenum meeting in November. Today, the proportion of China’s economy made up by domestic consumption is only around 35 percent, about half the level in the U.S. The logic of a stronger social safety net: Chinese who worry less about the future, including meeting the cost of health care and post-retirement living expenses, will spend more now.


Not Consumption Driven

Not Consumption Driven

How is this going to be done in a global economic system that does not sufficently vacuum the current account surpluses –particularly from China and Germany — when the goods producing nations are export driven with a household sector that consumes relatively little when compared to the Unites States. (Go here to understand the concept of surplus recycling).

Everything is interconnected. The recalcitrance of law makers in Washington adds to the confusion but also sets forward a more challenging path that will ensure greater hardship for the masses, be they in the savings prone east or the debt laden west.


Charts from Gary Shiling’s deck during the CFA Society Toronto 56th Annual Forecast Dinner on Tuesday, October 1, 2013.

Roberts, Dexter. “Forget About Retiring, China’s Economic Planners Say.” Bloomberg Businessweek, October 23, 2013. http://www.businessweek.com/articles/2013-10-23/forget-about-retiring-chinas-economic-planners-say(accessed October 24, 2013).

We care about consumption because it is ‘news’ – even when it really isn’t

Conspicuous consumption of valuable goods is a means of reputability to the gentleman of leisure. As wealth accumulates on his hands, his own unaided effort will not avail to sufficiently put his opulence in evidence by this method. The aid of friends and competitors is therefore brought in by resorting to the giving of valuable presents and expensive feasts and entertainments. Presents and feasts had probably another origin than that of naive ostentation, but they required their utility for this purpose very early, and they have retained that character to the present; so that their utility in this respect has now long been the substantial ground on which these usages rest.

Thorstein Veblen, The Theory of the Leisure Class: An Economic Study of Institutions, (Macmillan, 1899), 51-52.

Case in point: yesterday’s ‘news’ of a rapper/entertainer’s engagement to someone who does nothing  (below) centered around the cost and size of the engagement ring.

Werner to BBC: UK QE = FAIL

In both Japan and the UK, QE isn’t working, he says, because it doesn’t focus on “the most important part of the money supply”, which is bank lending. “UK QE has singularly failed, as bank credit is still shrinking.”

When faced with the claim used by some British banks that the demand for credit is low, Prof Werner is dismissive. “I’m quite used to this argument, because banks in Japan used it for 20 years,” he says. “The banks, of course, have become very risk-averse, as they have many non-performing assets.”

Prof Werner is also critical of the UK’s concentrated banking structure – which he argues has made the economy more vulnerable. “British banking is dominated by a small number of big banks – with just five banks controlling 90% of deposits,” he says.

Richard Werner talking to the BBC in their news item UK QE has failed, says quantitative easing inventor.

What is completely lost in that BBC article is that Werner has always emphasised that the effect of credit creation depends on the use of money. Werner cites two cases:

Case 1. The newly created purchasing power is used for transactions that are part of GDP. In this case, nominal GDP will expand: credit creation for ‘real economy transactions’ C(R) –> nominal growth can result in two outcomes

  1. Inflation without growth | Credit creation is used for consumption: more money coincides with the same amount of goods and services = consumptive credit creation
  2. Growth without inflation | Credit creation is used for productive credit creation: more money coincides with more goods and services = productive credit creation

Case 2. Newly created purchasing power is used for transactions that are not part of GDP (financial and real estate transactions). In this case, GDP is not directly affected, but asset prices must rise (i.e. asset inflation): credit creation for financial transaction C(F) –> asset markets.

  1. Asset inflation | Credit is used for financial and real estate speculation. More money circulates in the financial markets = speculative credit creation.

For a recent deck of his go here

One of the best books that few people know about let alone have read is Werner’s New Paradigm in Macroeconomics Solving the Riddle of Japanese Macroeconomic Performance

That will be covered in the future on this site as it will become more relevant that rate normalization will not be around the corner in Canada, USA or elsewhere where the debt burden for households is large, debt servicing long and the banking sector is fundamentally an extender of credit for real estate speculation, development and home buying rather than a lender for funding new startup entrepreneurial ventures that are critical to economic rejuvenation but also risky: most fail. There isn’t an immediate solution to the lack of funding for start ups but new models of peer to peer lending may be an option.