The finance penalty: overlarge financial sectors impose significant economic costs, according to major international research project

Countries including the UK suffer a growth penalty for failure to regulate finance

The findings of a major international research project, published today in a special issue of the Manchester School economics journal, remove any doubt that beyond a certain point, financial sectors become a major drain on countries’ economic performance.[1] The special issue marks the culmination of a project involving leading researchers from the US, Europe and India, including current and former experts from the International Monetary Fund and the Bank of International Settlements.

The studies in the special issue also demonstrate that the economic damage is likely to kick in at much lower sizes of the financial sector than previously considered – so that countries including the UK, which are far beyond the original estimates for the tipping point, are now likely to be experiencing a high, ongoing growth penalty.

Alex Cobham, Tax Justice Network chief executive, said:

“These results confirm, and go well beyond, the established findings in this area. We now have firm evidence that our financial sectors are causing serious damage to countries’ economic prospects. This is true above all in countries like the UK where finance has become bloated far beyond any productive contribution, distorting instead of supporting the economy. Policymakers have to be brave enough to act on these findings and take serious regulatory steps – before the next crisis, not after.”

Jesse Griffiths, chief executive of Finance Innovation Lab, said:

“Successive UK governments have treated the City of London as the ‘goose that lays the golden egg’, assuming that a bigger financial sector means a stronger economy. But this research shows that growth for growth’s sake is the wrong goal. We don’t need a bigger financial sector – we need a better one, aligned with the needs of the real economy, society and the planet.”

The special issue builds on a conference held earlier this year at the London School of Economics, jointly organised by Tax Justice Network, the International Inequalities Institute, the Balanced Economy Project, Finance Innovation Lab and the Atlantic Fellows for Social and Economic Equity, alongside the Manchester School journal.[2] The body of research on the potential damage caused by overlarge financial sectors builds from working papers published in 2012 by the International Monetary Fund, and by the Bank for International Settlements. The IMF paper, entitled ‘Too much finance?’, gave the name to the literature.[3]

Both sets of original authors of the two papers contributed to the special issue, revisiting and updating their findings. The authors of the IMF study (Jean-Louis Arcand, Enrico Berkes and Ugo Panizza) confirm and strengthen their original result, finding “a robust inverted‐U relationship between private credit and growth: financial depth is growth‐enhancing at low and moderate levels but exhibits diminishing returns and eventually becomes negative at high levels.” [4]

The authors of the BIS study (Stephen Cecchetti and Enisse Kharroubi) find now that the picture has worsened: “Our estimates of the tipping point—the level of credit‐to‐GDP above which additional credit becomes a drag on growth—are substantially lower than those we reported in the aftermath of the global financial crisis.” [5]

Cecchetti and Kharroubi find that the tipping point for credit to the private sector becoming damaging has fallen from around 100% of GDP, to just 40%. [6] For reference, the UK’s financial sector current generates a private credit-to-GDP ratio of some 112%. The eurozone average is a much healthier 77%, although while Germany and Spain are close to that, France has a much higher 108%. But the figure for the US, struggling with the types of inequality and corruption that some theories of excessive finance predict, is almost double: 201%.[7]

Another study in the special issue, with authors including Tax Justice Network researchers (Alex Cobham, David Cobham and Miroslav Palanský), looks beyond private credit and analyses the size of each country’s financial sector in the total economy in terms of its share in total value added.[8] Here the finding is even more bleak – in many cases, the relationship is purely negative, with countries facing economic costs that simply grow with the financial sector.

Other studies extend the ‘too much finance’ result in various ways. Arup Daripa, Sandeep Kapur and Marco Pelliccia focus on the mechanisms in which finance causes damage, and conclude that “in the presence of a large financial sector, the fear of market turmoil can damage growth even in the absence of an actual crisis episode.”[9] Daniel Carvalho finds that “higher levels of total financial assets of banks and non‐banks are negatively associated with GDP per capita growth”.[10] Thorsten Beck provides a critical review of the whole finance and development literature, and highlights evidence on the specific channel of banks switching from supporting business investment, which may be productivity-enhancing, to mortgage lending which may not.[11]

Jayati Ghosh makes a powerful case that countries of the global South are exposed to too much financial integration, and that appropriate capital controls may be needed to avoid the worst impacts.[12] Izaura Solipa and Gerald Epstein provide the first comprehensive analysis of the potential costs of ‘too much crypto’.[13].

-ENDS-

Notes to Editor

1. The Manchester School special issue is available here, including an editorial introduction (here) that provides an overview of the literature and the new contributions.
2. Full details about the conference including the programme can be accessed here.
3. The original IMF paper is here, and the original BIS paper here.
4. Jean-Louis Arcand is professor of economics at the Graduate Institute of International and Development Studies in Geneva, and also president of the Global Development Network. Enrico Berkes is Pausch Assistant Professor of economics at the University of Maryland. Ugo Panizza is professor of economics Pictet Chair in Finance and Development at the Geneva Graduate Institute, and director of the International Centre for Monetary and Banking Studies. Their new paper is available here.
5. Stephen Cecchetti is Rosen Family Chair in International Finance at the Brandeis International Business School, and Vice-Chair of the Advisory Scientific Committee of the European Systemic Risk Board. He was previously Economic Adviser and Head of the Monetary and Economic Department at the Bank for International Settlements. Enisse Kharroubi is principal economist at the Bank for International Settlements. Their new paper is available here.
6. Cecchetti and Kharroubi (p.2) note that a key factor explaining the lower tipping point is their inclusion of time‐fixed effects, “which filter out common movements in GDP and credit across countries… This suggests that global factors play an important role. That is, there is a sense in which the relationship depends less on what is happening in any particular country and more on what is happening to the financial system worldwide.” They also find that the relationship of credit with growth becomes purely negative in countries that also have large stock markets (as the UK does): “In countries with well‐developed stock markets, the inverted‐U pattern disappears entirely, and additional bank credit is associated with lower growth across all credit levels.”
7. Statistics for most recent year are taken from the World Bank database here.
8. Alex Cobham is chief executive at Tax Justice Network. David Cobham is emeritus professor at Heriot-Watt University. Miroslav Palanský is head of research at Tax Justice Network and assistant professor of economics at Charles University, Prague. Their paper is available here.
9. Arup Daripa is senior lecturer in economics at Birkbeck Business School. Sandeep Kapur is professor of economics at Birkbeck Business School. Marco Pelliccia is assistant professor of economics at Edinburgh Business School, Heriot-Watt University. Their paper is available here.
10. Daniel Carvalho is a senior economist at the Market Analysis Division of the Banco de Portugal. His paper is available here.
11. Thorsten Beck is director of the Florence School of Banking and Finance, Professor of Financial Stability at the European University Institute and co-chair of the Advisory Scientific Committee of the European Systemic Risk Board. His paper is available here.
12. Jayati Ghosh is professor of economics at the University of Massachusetts, Amherst, and co-chair of ICRICT (the Independent Commission for the Reform of International Corporate Taxation). Her paper is available here.
13. Izaura Solipa is postdoctoral research associate at Brown University’s William R. Rhodes Center for International Economics and Finance. Gerald Epstein is professor of economics, and co-director of PERI, at University of Massachusetts, Amherst. Their paper is available here.