Is the Financial Sector Hindering Productive Growth ?

Is it fair to blame one industry for a widespread decline in productivity and chronically slow growth?

Surely there are other factors responsible making it - as is so often the preference in this society - impossible to pin accountability on anyone or anything.

But recently the Bank of International Settlements has done just that. And not only does it assign blame, the bank's report goes so far as to state that the relationship between financialization and slowing, unproductive growth is causal. 

Gasp! It is rare to have one of these J'Accuse! moments in contemporary economic life. Everyone wants to be polite and keep the wheels of commerce turning for fear that the alternative might be even worse.

The problem is that public policy - and those who make it - is having a prolonged Stockholm Syndrome episode. Authorities are too fearful of the consequences to bring charges for behaviors that led to the 2007-8 financial crisis. Austerity remains the economic order of choice because it supposedly supports the financial services industry, contrary to the obvious benefits that quantitative easing had on financial markets - and the evident glee with which it was embraced in fact if not in political rhetoric.

The even greater concern is that too many believe that finance is the only profession in which the west can compete. The recent numbers from New York City showing that employment growth has rebounded strongly without growth in financial services demonstrates - at least in that city, as ostensibly dependent on finance as any other on earth the fallacy of that proposition.

The fact is that industries themselves are rarely guilty of causing one sort of result or another. But the application of political power borne of the assets derived from an industry's or profession's success, accompanied by the support of supplicants and beneficiaries driven by the fear of the alternative that often drives such behavior may cause such outcomes.

Efforts to rein in financial services will continue with varying degrees of success. Opposition from those being regulated will be just as fierce because they recognize the threat. The question is to what degree finance can be encouraged to provide the important service for which it was designed without overwhelming the economy it was established to serve, not dominate.  JL

Matthew Klein reports in the Financial Times:

Financial booms are not, in general, growth-enhancing. Encourage(ing) an unproductive, resource-hoarding industry to get smaller might be exactly what’s needed in economies plagued by chronically slow growth.
Productivity growth in the rich world started slowing down around the same time that the financial sector’s share of economic activity started rising rapidly. A new paper from the Bank for International Settlements suggests a causal connection.
First, the high salaries commanded in the financial sector — much of which can be attributed to too-big-to-fail subsidies and other forms of rent extraction — make it harder for genuinely innovative firms to hire researchers and invest in new technologies.
Second, the growth of the financial sector has been concentrated in mortgage lending, which means that more lending usually just leads to more building. That’s a problem for aggregate productivity, since the construction industry is one of the few that has consistently gotten less productive over time. For example, Spain had no productivity growth between 1998 and 2007, a period when 20 per cent of all the net job growth can be attributed to the building sector.
As they put it:

Industries that are in competition for resources with finance are particularly damaged by financial booms. Specifically, we find that manufacturing sectors that are either R&D-intensive or dependent on external finance suffer disproportionate reductions in productivity growth when finance booms. That is, we confirm the results in the model: by draining resources from the real economy, financial sector growth becomes a drag on real growth.

Before we go any further, it’s worth illustrating a few of these stylised facts. The Federal Reserve Bank of San Francisco produces a quarterly series measuring the productivity of the US business sector adjusted for utilisation and changes in composition. This ought to be a pure measure of the extent to which GDP is boosted by technological and managerial progress rather than, say, people working more hours, getting more schooling, or having more capital at their disposal.
Here’s the chart:

Productivity growth was rapid and steady until the mid-1970s, then flatlined until the mid-1990s. Growth briefly came back from 1996-2004 before stopping again. We would be about 60 per cent richer now, had productivity growth not broken its earlier trend.
One way to measure the relative size of the financial sector is to look at its share of total domestic corporate profits. We made sure to exclude the profits earned by the Fed’s seigniorage since that just reflects the size and composition of the central bank’s balance sheet. Here’s the chart:

For roughly 40 years, the financial sector stayed roughly the same size relative to the rest of the economy. Then a phase shift occurred, starting in the late 1980s, and it has since commanded a share twice as large. Despite plenty of cyclicality around its average, the underlying trend was remarkably stable in both periods.
If you put these two charts together you notice something interesting: the growth rate in productivity was systematically faster when the finance sector was relatively smaller, and then when the finance sector got bigger, productivity growth got smaller. It’s easier to see this point if we compare average productivity growth over the two time periods against the finance sector’s average profit share:

The dark red column nearly doubled in height and the pale pink column shrank by about half.
The economists at the BIS went beyond our hunch and did an industry-level analysis across rich countries. Their theory is that sectors that require lots of skilled labour and that lack collateral to secure loans — aerospace, information technology, pharma, etc — will be disproportionately hurt by the growth of finance compared to other industries. What they found:

A sector with high R&D intensity located in a country whose financial system is growing rapidly grows between 1.9 and 2.9% a year slower than a sector with low R&D intensity located in a country whose financial system is growing slowly. This supports the conclusion we reached using the financial dependence variable: the effect is large…Financial booms are not, in general, growth-enhancing.

The interesting question, then, is whether this process can be put into reverse. Maybe there is a deeper wisdom behind financial regulations that appear to be (at best) pointless. Harassment that encourages an unproductive, resource-hoarding industry to get smaller might be exactly what’s needed in economies plagued by chronically slow growth.