This week, ex-banker Charles Morris, who was featured in the documentary Inside Job, brings us compelling evidence that countries with a large financial sector create lesser economic growth than countries that have restrained that sector. While a well-functioning financial system is key to growth, there’s a balance that needs to be struck, Morris writes:
Once the financial sector achieves a certain size, its continued expansion reduces economic growth, according to a new study by two senior economists at the Bank for International Settlements, Stephen Cecchetti and Enisse Kharroubi, using a large international data base stretching back more than 30 years [...]
An outsized financial sector expansion can actually reduce economic growth, according to their data. This relationship holds for country after country, and the tipping points are fairly consistent. When private credit grows to between 90 percent and 100 percent of gross domestic product, it is tilting toward too big. In the runup to the 1997-98 Asian financial crises, Thai private credit outstanding grew to 150 percent of GDP and growth turned sharply down. As soon as credit was ratcheted back to 95 percent of GDP, however, Thai productivity picked up sharply.
New Zealand’s economy offers much the same picture. As its financial sector expanded beyond the 100 percent mark, productivity dropped sharply, then rose again as credit was brought under control. Ireland and Spain show a similar pattern.
The sector that typically bears the brunt of hyper-financialization is manufacturing – especially the heavy industries that need working capital to finance materials and work in process. The next most damaged are research-and-development-intensive businesses, perhaps because finance siphons away too much of the best science and math talent. Whatever the reason, when American finance bulked up in the 2000s, there was a cataclysmic fall in manufacturing employment.
You can easily see real-world examples of how a giant financial sector stunts growth. Because of the consolidation of the banking sector, consumer loans invariably come from the leading mega-banks, allowing them to collude for higher fees. They took advantage of the Fed’s QE3 by increasing the spread they reap for individual loans, and now borrowing rates are nudging back up. Just as banks control the largest consumer loans, they are now pushing into the payday loan space. As they control bigger segments of the loan market, they take advantage of reduced competition to increase their profits at the expense of consumers. Clearly this stunts economic growth as the benefits flow to the top. Rent-seeking is damaging to a country’s economy.
Over-financialization is also closely aligned with inequality, as we’ve seen in America for the last 30 years. The Economist describes the two Americas, and they give a series of reasons for it, including the runaway financial sector.
A disproportionate, and growing, chunk of the very rich, however, have made their money in Wall Street rather than Main Street. An analysis by Mr Kaplan and Joshua Rauh, now of Stanford University, shows that the share of investment bankers among the top 0.1% is larger than the share of senior executives. America’s top 25 hedge-fund managers make more than all the CEOs of the S&P 500 combined. The financial industry’s outsize pay partly reflects its growth. For good or ill, finance’s share of American GDP soared between 1980 and 2007. Capital markets have globalised faster and more comprehensively than any other part of the economy, enabling hedge funds and other asset managers to deploy ever bigger pools of funds. According to Thomas Philippon of New York University and Ariell Reshef of the University of Virginia, financiers also have higher skill levels than they did a generation ago.
These fundamental economic shifts explain part of the rise in Wall Street incomes, but not all of it. Messrs Philippon and Reshef argue that between a third and half of Wall Street’s higher pay is unjustified, deriving from rents rather than productivity. But what explains these rents? Luigi Zingales of the University of Chicago points out that one source is the implicit subsidy (through lower borrowing costs) that banks enjoy by being too big to fail. He reckons this subsidy is worth some $30 billion a year, enough to fund a fair few bonuses. Others point to a broader cronyism between Wall Street and Washington over the past 30 years which has allowed financiers to tilt rules in their favour. The finance industry (along with property and insurance) employs more lobbyists than virtually any other industry, around four per Congressman.
Financiers have also been among the biggest winners from changes to America’s tax code. The country’s top rate of income tax has been repeatedly slashed since 1980, from 70% to 35%. By itself, that reduction has not greatly affected average tax burdens at the top (since there have been enough loopholes to ensure that few people paid the top rate). America’s richest have gained more from reductions in the capital-gains tax, which is now only 15%. Private-equity moguls have done particularly well, since the tax code allows them to classify their income as capital gains.
All of this argues for a significant curtailing of the sector as a means of economic self-preservation. President Obama hinted at a preference toward rules constraining executive pay in an interview with Rolling Stone this week, but it’s simply much easier to game compensation rules – many of which already exist and merely led to shifts into stock options from salary – than it is to break up the banks themselves. Until that occurs, banks will continue to use rent-seeking, outsized risk and outright fraud to capture record profits. As Morris writes in his opinion piece, banks have been settling fraud claims on a near-constant basis since 2000. It’s been the cost of doing business, and business has been good. And none of this has really stopped since the financial crisis. The way to reduce the risk to the economy, allow for faster growth, ensure accountability and shut down the Wall Street casino is to cut the banks down to size.