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How Much Finance Is Too Much?

Is the finance sector too big?

14May

The financial and insurances sector accounted for 8% of the UK’s GVA in 2014, and a similar figure in the USA. But how large can the finance sector get before it stops being good for the economy?

The financial crash of 2008 and the ensuing Great Recession suggests there is certainly a limit, something a new discussion paper by IMF economists appears to confirm. The paper, titled Rethinking Financial Deepening: Stability and Growth in Emerging Markets, points to its new Financial Development Index to show that there is an optimal level of financial development, with one of its authors noting in a blog that: ‘Beyond a certain level of financial development, the positive effect on economic growth begins to decline, while costs in terms of economic and financial volatility begin to rise.’

The finance industry has had many detractors since the crisis, spurred by the tendency of various banks to embroil themselves in widely publicized scandals. One upcoming paper by University of Chicago economist Luigi Zingales argues that there is nothing to ‘support the notion that all growth of the financial sector in the last 40 years has been beneficial to society.’ Stephen Cecchetti of the Bank for International Settlements, meanwhile, has criticized the impact of the large monetary rewards offered by banks, deriding them for enticing the best and brightest students away from projects that could have a better social impact.

The Financial Development Index used by the IMF took data from 176 countries during the years between 1980 and 2013 to quantify how deeply the banking sector had penetrated their economies. It showed how much raw credit banks and other financial institutions issued, as well as a countries’ depth of access to bank accounts and financial products. It then showed the index on a bell curve, which revealed that once countries reach a certain point on the index, the effect on economic growth begins to fall. The US, Japan, and Ireland have all passed this point already, and productivity has dropped and investments become decreasingly efficient as a result.

The IMF's discovery that the financial sector eventually becomes an albatross around the neck of economic growth joins a host of research that has snowballed since the crisis. However, it offers few original solutions. The major finding of the report is that good regulation can often curb the negatives of excessive financial sector growth. But the report offers few ideas as to overcoming resistance to regulations from the banks. Anti-finance sentiment is bad, not just for the economy but society as a whole. Zingales argues that the financial sector, in its proper role, ‘fosters growth, promotes entrepreneurship, favors education, alleviates poverty and reduces inequality’, but this gets lost in a sea of public disdain as banks perpetrate scandal after scandal. The IMF’s Index may simply prove what many already believed, but it could also provide the spark that sees more sensible regulation introduced and turn the tide on damaging anti-finance sentiment. At what point is it more profitable for banks to simply accede to new regulations without complaint than suffer constant reputational damage? 

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