Thursday, August 28, 2014
4

The Banks that Ate the Economy

LONDON – Bank of England Governor Mark Carney surprised his audience at a conference late last year by speculating that banking assets in London could grow to more than nine times Britain’s GDP by 2050. His forecast represented a simple extrapolation of two trends: continued financial deepening worldwide (that is, faster growth of financial assets than of the real economy), and London’s maintenance of its share of the global financial business.

These may be reasonable assumptions, but the estimate was deeply unsettling to many. Hosting a huge financial center, with outsize domestic banks, can be costly to taxpayers. In Iceland and Ireland, banks outgrew their governments’ ability to support them when needed. The result was disastrous.

Quite apart from the potential bailout costs, some argue that financial hypertrophy harms the real economy by syphoning off talent and resources that could better be deployed elsewhere. But Carney argues that, on the contrary, the rest of the British economy benefits from having a global financial center in its midst. “Being at the heart of the global financial system,” he said, “broadens the investment opportunities for the institutions that look after British savings, and reinforces the ability of UK manufacturing and creative industries to compete globally.”

That is certainly the assumption on which the London market has been built and the line that successive governments have peddled. But it is coming under fire.

Andy Haldane, one of the lieutenants Carney inherited at the BoE, has questioned the financial sector’s economic contribution, pointing to “its ability to both invigorate and incapacitate large parts of the non-financial economy.” He argues (in a speech revealingly entitled “The Contribution of the Financial Sector: Miracle or Mirage?”) that the financial sector’s reported contribution to GDP has been significantly overrated.

Two recent papers raise further doubts. In “The Growth of Modern Finance,” Robin Greenwood and David Scharfstein of Harvard Business School show that the share of finance in US GDP almost doubled between 1980 and 2006, just before the onset of the financial crisis, from 4.9% to 8.3%. The two main factors driving that increase were the expansion of credit and the rapid rise in resources devoted to asset management (associated, not coincidentally, with the exponential growth in financial-sector incomes).

Greenwood and Scharfstein argue that increased financialization was a mixed blessing. There may have been more savings opportunities for households and more diverse funding sources for firms, but the added value of asset-management activity was illusory. Much of it involved costly churning of portfolios, while increased leverage implied fragility for the financial system as a whole and imposed severe social costs as over-exposed households subsequently went bankrupt.

Stephen G. Cecchetti and Enisse Kharroubi of the Bank for International Settlements – the central banks’ central bank – go further. They argue that rapid financial-sector growth reduces productivity growth in other sectors. Using a sample of 20 developed countries, they find a negative correlation between the financial sector’s share of GDP and the health of the real economy.

The reasons for this relationship are not easy to establish definitively, and the authors’ conclusions are controversial. But it is clear that financial firms compete with others for resources, and especially for skilled labor. Physicists or engineers with doctorates can choose to develop complex mathematical models of market movements for investment banks or hedge funds, where they are known colloquially as “rocket scientists.” Or they could use their talents to design, say, real rockets.

Cecchetti and Kharroubi find evidence that it is indeed research-intensive firms that suffer most when finance is booming. These companies find it harder to recruit skilled graduates when financial firms can pay higher salaries. And we are not just talking about the so-called “quants.” In the years before the 2008 financial crisis, more than a third of Harvard MBAs, and a similar proportion of graduates of the London School of Economics, went to work for financial firms. (Some might cynically say that keeping MBAs and economists out of real businesses is a blessing, but I doubt that that is really true.)

The authors find another intriguing effect, too. Periods of rapid growth in lending are often associated with construction booms, partly because real-estate assets are relatively easy to post as collateral for loans. But the rate of productivity growth in construction is low, and the value of many credit-fueled projects subsequently turns out to be low or negative.

So, should Britons look forward with enthusiasm to the future sketched by Carney? Aspiring derivatives traders certainly will be more confident of their career prospects. And other parts of the economy that provide services to the financial sector – Porsche dealers and strip clubs, for example – will be similarly encouraged.

But if finance continues to take a disproportionate number of the best and the brightest, there could be little British manufacturing left by 2050, and even fewer hi-tech firms than today. Anyone concerned about economic imbalances, and about excessive reliance on a volatile financial sector, will certainly hope that this aspect of the BoE’s “forward guidance” proves as unreliable as its forecasts of unemployment have been.

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  1. CommentedMazhar Can

    Is it very difficult to comprehend benefits from a Britain who has the most comparative advantage in international banking/finance (at least in Europe)? How is this very different from the risk you may have by endeavouring to build more productivity in real sector- if you slightly believe in market efficiency/laissez-faire economy? Despite risks involved, sharpe ratio for finance is still relatively high. The problem is to find the delicate balance from spillovers to rest of the economy in case of a financial bust. Simply claiming banks are bad is wrong and comparing historical woes of Ireland/Iceland (by just focusing on their out-sized banking systems) with Britain's yet-to-materialize future is unfair.

  2. CommentedOlivier Francoeur

    Well that's good.
    The sooner insolvent banks collapse, the better off we all are.
    And the Government has no business getting involved;
    The Pharaoh is not any more Divine than me and you.
    Read Hans-Hermann Hoppe and get a clue.

  3. CommentedJan Smith

    The more general problem is an increasing divergence between the growth of income of the economic elite, including but not limited to the financial elite, and the growth of national income. This in turn escalates political conflict between the economic elite and the knowledge elite. If there is little overlap between these two groups, as in the US, the economic elite will use both ideological capture of the knowledge elite (think Greenspan, perhaps even Summers) and covert funding of crackpots, witch-hunters, etc who resent and despose the knowledge elite. This may not lead to fascism in the US or UK but almost certainly it will destroy both civility and economic growth.

  4. CommentedFabio Souza

    We must also remember Cyprus last banking crisis in EU (http://www.aei.org/files/2013/04/22/-bert-ely-presentation_1517081685.pdf). According with Bert Ely, the country hadabout 8 times its GDP at March 31, 2012. And 80% of its GDP came from services.

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