New research shows that runaway growth in the financial sector is detrimental to the real economy, as highly skilled workers gravitate toward finance and industries dependent on outside investment suffer. (Reuters)
New research shows that runaway growth in the financial sector is detrimental to the real economy, as highly skilled workers gravitate toward finance and industries dependent on outside investment suffer. (Reuters)

Mainstream political thinking holds that a nation's economic fortitude relies on an ever-expanding financial sector. But new research disputes the notion. In a new paper titled “Why does financial sector growth crowd out real economic growth?” authors Stephen Cecchetti and Enisse Kharroubi show that when banking blossoms, the “real” economy withers.

To see the way the economies of developed nations have transformed in the past few decades, look no further than the career choices of elite college students.

“When I was in school, everyone wanted to fly to Mars or invent cold fusion,” says Cecchetti, a professor of economics at Brandeis International Business School. “In the '90s, everyone wanted to become hedge fund managers.”

The shift in skilled workers toward finance plays a central role in the study. But the paper goes deeper to show how these shifts have affected real economies.

"Textbooks tell you that financial intermediation is about efficient capital allocation.” Cecchetti says. As the theory goes, society needs a sector that stokes innovation by bankrolling research and identifying promising companies. This lines up with what Cecchetti and Kharroubi have seen in smaller economies with modest financial services. “In frontier and emerging-market economies, you have to make sure that the financial infrastructure is there.”

But there’s a limit. “Up to a point, it’s better for the real economy,” Cecchetti says of financial growth. “Then it starts to become a drag.”

Researchers have previously observed that financial booms tend to correlate with malaise in the real economy. Cecchetti and Kharroubi confirmed the notion in a 2012 paper that found “a fast-growing financial sector is detrimental to aggregate productivity growth.”

Their latest paper breaks new ground in describing how that relationship evolves. They show that industries with high research and development costs – aircraft manufacturing, for instance – actively suffer when the financial sector grows too fast.

Cecchetti sees two main reasons for this. “First, the financial sector is sucking high-skilled labor out of the real economy,” he says. For example, more than a third of Princeton students who landed a job upon graduating in 2010 entered financial professions. “We’re probably better off if the smartest people go into the sciences than if they go into finance,” Cecchetti says.

But there are more subtle factors at play. Some industries benefit from financial sector growth, particularly those that can put up tangible assets as collateral on loans. “Car dealers get loans for their inventories,” Cecchetti explains. “If the dealer defaults, the bank’s going to seize the cars.” Investment follows readily available collateral; it’s safer to make a loan when there’s something to repossess if a deal sours.

But research-intensive industries with comparatively little collateral, like medical equipment or communications, lose out when financial growth gets out of hand. To test the hypothesis, Cecchetti and Kharroubi compared the economic histories of 15 countries. They found that these R&D-heavy industries – the ones that depend especially on finance and investment – grew 2.5 percent a year slower in countries experiencing significant financial booms.

"It’s hard for me to look at a lot of what’s going on and say this is efficient capital allocation,” says Cecchetti. “Instead, we have people who try to take little nicks out of everybody else.”

Cecchetti has no particular animus toward the financial industry. He served as the head of the Monetary and Economic Department at the Bank for International Settlements, the so-called central banker’s central bank, and previously worked for the Federal Reserve Bank of New York. He literally wrote the book on money, banking and financial markets.

But runaway financial sectors in the 2000s gave him pause. In countries like Ireland and Spain, annual financial growth was approaching 15 percent. As it turns out, this had real consequences for the underlying economies, which tumbled in the worldwide financial crisis.

Cecchetti is hesitant to prescribe any remedies for society at large. “If there’s a lesson in this,” he offers, “it’s to ensure that you have a system that’s structured to provide the foundations for strong and sustainable growth.”

That said, Cecchetti wouldn’t mind if bright young workers gravitated toward the sciences in greater numbers. “It would also be nice to have room-temperature super-conductors.”