Study: A Large Financial Sector Can Impede Economic Growth

Over the last several decades, the financial sector has made up a larger and larger percentage of the U.S. economy, eventually accounting for 40 percent of corporate profits before the financial crisis of 2008. By the end of 2011, even as Americans on Main Street were still grappling with the effects of the Great Recession, finance made up a larger percentage of the economy than it did before the crash.

The financial sector is supposed to promote growth by allocating capital to useful parts of the economy, but is that what it’s really doing? In a new working paper for the International Monetary Fund, Ugo Panizza, an economist with the United Nations Conference on Trade and Development, and two other economists found that a smaller financial sector can actually be good for economic growth:

In a new Working Paper titled “Too Much Finance?” and published by the International Monetary Fund, Jean Louis Arcand, Enrico Berkes, and I use various econometric techniques to test whether it is true that limiting the size of the financial sector has a negative effect on economic growth. We reproduce one standard result: at intermediate levels of financial depth, there is a positive relationship between the size of the financial system and economic growth. However, we also show that, at high levels of financial depth, a larger financial sector is associated with less growth. Our findings show that there can be “too much” finance. While Greenspan argued that less credit may hurt our future standard of living, our results indicate that, in countries with very large financial sectors, regulatory policies that reduce the size of the financial sector may have a positive effect on economic growth.

The authors add that “our analysis suggests that there are several countries for which smaller financial sectors would actually be desirable,” as a financial sector that is too large increases the odds of a crisis and increases the misallocation of capital to less useful sectors of the economy. But of course, any efforts to shrink some of the financial behemoths in the U.S. — or to separate out risky trading from more traditional lending — are met with howls from conservatives.