Con­trary to what one might be­lieve, it might not be ben­e­fi­cial for a coun­try to have an overly large fi­nan­cial sec­tor. We take a look at the neg­a­tive ef­fects this can have on an econ­omy.

Finweek English Edition - - FRONT PAGE - ed­i­to­rial@fin­ Johan Fourie is as­so­ciate pro­fes­sor in Eco­nomics at Stel­len­bosch Uni­ver­sity.

most econ­o­mists would agree that a grow­ing econ­omy re­quires a well-func­tion­ing fi­nan­cial sys­tem that is able to move cap­i­tal be­tween its own­ers and those who need it. The larger the fi­nan­cial sec­tor, the ar­gu­ment goes, the more likely it is that cap­i­tal will be ef­fi­ciently al­lo­cated, and the bet­ter for the econ­omy. Of course, the same is true for other in­ter­me­di­ate ser­vices, from law and con­sult­ing to au­dit­ing and mar­ket­ing, which per­form in­ter­me­di­ate ser­vices that help firms to spe­cialise, and flour­ish.

But a new work­ing pa­per by econ­o­mists Stephen Cec­chetti and Enisse Khar­roubi at the Bank for In­ter­na­tional Set­tle­ments ques­tions this logic. They ar­gue in­stead that a too-large in­ter­me­di­ate sec­tor (they specif­i­cally re­fer to fi­nance) can ac­tu­ally hurt growth, and find that there is a thresh­old be­yond which growth of the fi­nance in­dus­try ac­tu­ally re­duces to­tal fac­tor pro­duc­tiv­ity growth.

All de­vel­oped economies are al­ready be­yond this thresh­old, they find, and pro­vide ev­i­dence of a clear neg­a­tive cor­re­la­tion be­tween fi­nan­cial sec­tor growth and R&D-in­ten­sive in­dus­tries.

One mech­a­nism through which this hap­pens is that fi­nance con­sumes re­sources that could have been utilised more pro­duc­tively in other sec­tors. A com­plex fi­nan­cial sys­tem needs highly qual­i­fied engi­neers, for ex­am­ple, clever peo­ple that could have been em­ployed in re­search in­dus­tries that would have had a big­ger im­pact on so­ci­ety.

This is wor­ry­ing for a coun­try like South Africa where fi­nan­cial and other in­ter­me­di­ate ser­vices are, like the US, a large part of the econ­omy.

The more fi­nance and other in­ter­me­di­ate ser­vice firms em­ploy our smartest stu­dents (a pre­cious re­source), the fewer there are of them to start their own busi­nesses pro­duc­ing goods that we can ex­port, or do­ing re­search that can in­vent new things. I’ve seen this my­self: the largest con­sult­ing firms pil­fer our best grad­u­ates (promis­ing the in­comes and sta­tus that come with these jobs) at the ex­pense of far less ap­peal­ing jobs in in­dus­tries that our econ­omy des­per­ately needs. Who wants to work in a fac­tory any­way?

In their book Con­crete Eco­nomics, Brad De­long and Stephen Co­hen ex­plain why the fi­nance in­dus­try grew so rapidly, from roughly 3% in 1950 to al­most 9% of US GDP to­day. It hap­pened as a re­sult of the dereg­u­la­tion that al­ready be­gan in the 1970s but in­ten­si­fied in the 1990s. Some of this was good, like the in­no­va­tion of low-cost bro­ker­ages and low-cost in­vest­ment funds, just like the reg­u­la­tors had hoped. Un­for­tu­nately, these were the ex­cep­tions rather than the rule.

Fi­nan­cial in­ter­me­di­aries soon re­alised that it is much eas­ier to prom­ise clients that “they could beat the mar­ket and be­come rich” than pro­vide value to their clients by “soberly match­ing risks to riskbear­ing ca­pac­ity”.

And so, in­stead of charg­ing lower fees, which would ben­e­fit in­vestors, a freer mar­ket made fi­nan­cial in­ter­me­di­aries move into fancy of­fice blocks, re­cruit­ing the smartest minds, and charge higher fees as a sig­nal that their port­fo­lios are the ones with the best re­turns.

In South Africa, I would ven­ture that this also hap­pened in other in­ter­me­di­ate sec­tors, like au­dit­ing and con­sult­ing. Be­tween 1981 and 2006, our ser­vice sec­tor in­creased by 42%.

Fi­nance may have ben­e­fit­ted from dereg­u­la­tion, but the tight­en­ing of ac­count­ing stan­dards and other types of well-in­ten­tioned reg­u­la­tion to safe­guard busi­nesses from fraud­u­lent prac­tices meant that these highly con­cen­trated in­dus­tries had a cap­tured mar­ket for their ser­vices. High prices – and Sand­ton of­fice tow­ers – fol­lowed.

Our large in­ter­me­di­ate ser­vices sec­tor means that we have fewer in­no­va­tive firms that can pro­duce prod­ucts and ser­vices to sell to a global au­di­ence. Our best minds should be de­vel­op­ing new ge­net­i­cally mod­i­fied crops or mo­bile apps, not more com­plex fi­nan­cial in­stru­ments.

How we fix this is a more dif­fi­cult ques­tion. It is un­likely that change will come from within these firms; in fact, ex­pect lob­by­ing for more rules and higher stan­dards which re­quire big­ger teams of ex­perts sell­ing bet­ter ad­vice. Why kill the goose that lays the golden eggs? A con­certed ef­fort by gov­ern­ment is in­stead nec­es­sary to re­duce the de­mand for and mar­ket power of these in­ter­me­di­ate ser­vices firms. Re­duc­ing ex­ces­sive bu­reau­cratic red tape can help with the for­mer. Com­pe­ti­tion pol­icy can help with the lat­ter.

Per­haps the em­pha­sis should in­stead be on grow­ing other sec­tors, specif­i­cally man­u­fac­tur­ing. But what reg­u­la­tors should re­alise is that big­ger is not al­ways bet­ter when it comes to fi­nance and other in­ter­me­di­ate ser­vice in­dus­tries.

A com­plex fi­nan­cial sys­tem needs highly qual­i­fied engi­neers, for ex­am­ple, clever peo­ple that could have been em­ployed in re­search in­dus­tries that would have had a big­ger im­pact on so­ci­ety.

Enisse Khar­roubi Econ­o­mist at the Bank for In­ter­na­tional Set­tle­ments

Stephen Cec­chetti Econ­o­mist at the Bank for In­ter­na­tional Set­tle­ments

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