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

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s