NOTE: The following article is based on a paper by Economic Adviser at the Bank for International Settlements (BIS) Stephen G. Cecchetti and his colleague Enisse Kharroubi. The full publication is available at BIS website. You can also download it here.
One of the principal conclusions of modern economics is that finance is good for growth. But recent experience has led many people to question whether this conclusion is definitive. Is it true regardless of the size and growth rate of the financial system? Or, like a person who eats too much, does the financial system become a bloated drag on the rest of the economy?
We examined the impact of the size and growth of the financial system on aggregate economies and looked at its impact on productivity at the level of individual manufacturing industries. Here are some of our conclusions:
- As is the case with many things in life, with finance you can have too much of a good thing. At low levels, a larger financial system goes hand in hand with higher productivity growth. But there comes a point – one that many advanced economies passed long ago – where more banking and more credit lower growth.
- Financial booms are bad for trend growth. Big and fast-growing financial sectors can be very costly for the rest of the economy. They draw in essential resources in a way that hurts other sectors of the economy.
- Financial sector growth disproportionately harms industries that are either financially dependent or R&D-intensive.
Thailand is an interesting example. In the run-up to the Asian crisis of 1997–98, the ratio of Thai private credit to GDP reached 150%. More recently, this measure of financial sector size has fallen to roughly 95%. This time, the result is a benefit of roughly one half of 1 percentage point in trend productivity growth.
Take the example of the United States, where private credit grew to more than 200% of GDP by the time of the financial crisis. Reducing this to a number closer to 100% would, by our estimates, reap a productivity growth gain of more than 150 basis points.
Ireland and Spain are admittedly extreme cases. During the five years beginning 2005, Irish and Spanish financial sector employment grew at an average rate of 4.1% and 1.4% per year, while output per worker fell by 2.7% and 1.4%, respectively. Our estimates imply that if financial sector employment had been constant in these two countries, it would have shaved 1.4 percentage points from the decline in Ireland and 0.6 percentage points in Spain. In other words, by our reckoning financial sector growth accounts for one third of the decline in Irish output per worker and 40% of the drop in Spanish output per worker.