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“Financial sector crowds out real growth”

Secular stagnation and the financial sector
[Via Crooked Timber]

In my last post on private infrastructure finance and secular stagnation, I suggested a bigger argument that

The financialization of the global economy has produced a hugely costly financial sector, extracting returns that must, in the end, be taken out of the returns to investment of all kinds. The costs were hidden during the pre-crisis bubble era, but are now evident to everyone, including potential investors. So, even massively expansionary monetary policy doesn’t produce much in the way of new private investment.

This isn’t an original idea. The Bank of International Settlements put out a paper earlier this year arguing that financial sector growth crowds out real growth. But how does this work and what can be done about it? I’m still organizing my thoughts on this, so what I have are some ideas rather than a fully formed argument.

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We are starting to get some people examining just how the growth of the financial sector disrupts an effective economy. The BIS paper is even entitled “Why does financial sector growth crowd out real economic growth.

Here is the abstract (my bold):

In this paper we examine the negative relationship between the rate of growth of the financial sector and the rate of growth of total factor productivity. We begin by showing that by disproportionately benefiting high collateral/low productivity projects, an exogenous increase in finance reduces total factor productivity growth. Then, in a model with skilled workers and endogenous financial sector growth, we establish the possibility of multiple equilibria. In the equilibrium where skilled labour works in finance, the financial sector grows more quickly at the expense of the real economy. We go on to show that consistent with this theory, financial growth disproportionately harms financially dependent and R&D-intensive industries.

So when skilled labor enters finance, that sector grows at the expense of the economy. It is a zero-sum game, harming everyone while it helps itself.

What have we seen over the last 40 years? Some of the most educated people going to Wall Street in search of more money. And they succeeded, to the detriment of all of us. Much lower GDP growth. Income inequality. Stagnant economy. Investment bubbles. Debt bubbles.

Capitalism is very effective at distributing the products manufactured from scarce resources. It does this by an effective collaboration between those with capital and those who do the work.

Rent-seeking behaviors – where money is used to create more money, not things – does not appear to enhance the economy as much as “extracting returns that must, in the end, be taken out of the returns to investment of all kinds.

When deciding where to put their capital, investors can put it into classic capitalistic markets in order to make things, and seeing a return on that investment. 

Or they can invest in the financial sector, which makes nothing but – through a variety of manipulations including debt escalation and political capture – provides a higher return. The former is speculative, with a real moral hazard. The latter is not, with little or no real moral hazard to speak of.

So investment, instead of going to make things, goes to make more money. Money which really helps few, including Capital or Labor. It only helps the renters.

The growth of the financial sector damages the overall economy, reduces research and the growth of new companies. It grows at the expense of the overall economy, like a parasite.

Image: Pictures of Money