by Don Alexander, MBA
Associate, RSD Solutions Inc.
One of the principal conclusions of modern economics is that finance is good for growth. The idea that an economy needs intermediation to match borrowers and lenders, channeling resources to their most efficient uses, is fundamental to our thinking. There is evidence supporting the view that financial development is good for growth and a causal link between finance and growth. This, in turn, was one of the key elements supporting arguments for financial deregulation.
Recent research by Steve Cecchetti & Enisse Karroubi from the BIS paper, Reassessing the impact of finance on growth, investigates how financial development affects aggregate productivity growth. This question is addressed by examining the impact of the size and growth of the financial system on productivity growth at the level of aggregate economies. Based on a sample of developed and emerging economies, the authors show that the level of financial development is good only up to a point, after which it becomes a drag on growth. Second, focusing on advanced economies, they indicate that a fast-growing financial sector can be detrimental to aggregate productivity growth.
At first, these results may seem surprising. After all, a more developed financial system is supposed to reduce transaction costs, raising investment directly, as well as improving the distribution of capital and risk across the economy. These two channels, operating through the level and composition of investment, are the mechanisms by which financial development improves growth. But the financial industry competes for resources with the rest of the economy. It requires not only physical capital, in the form of buildings, computers and the like, but highly skilled workers as well. Overall, the lesson is that 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 is detrimental to growth at the aggregate level.
The authors suggest the complex real effects of financial development and come to two important conclusions. First, financial sector size has an inverted U-shaped effect on productivity growth. That is, there comes a point where further enlargement of the financial system can reduce real growth. Second, financial sector growth is found to be a drag on productivity growth. The authors’ interpretation is that because the financial sector competes with the rest of the economy for scarce resources, financial booms are not, in general, growth enhancing. This evidence, together with recent experience during the financial crisis, leads to a conclusion that there is a pressing need to reassess the relationship of finance and real growth in modern economic systems. More finance is definitely not always better.
The increased role of finance has increased the complexity of risk management. Perhaps, it might be time to simplify the process.
For more on this, follow the link: www.bis.org/publ/work381.htm
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