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COLUMN-Finance, or why we can’t have nice things: James Saft

(James Saft is a Reuters columnist. The opinions expressed are
his own)

By James Saft

n>Feb 17 (Reuters) – It is more than a coincidence: the growth
of finance really is holding the rest of the economy back.

Even worse, according to a new paper from the Bank for
International Settlements (www.bis.org/publ/work490.pdf),
this likely happens in part because we have too many clever
bankers who would be producing more of value as aerospace
designers or drug researchers.

Good thing then, that we have complex mortgage products to
divert us while we are suffering from uncured diseases and not
riding in faster, cheaper and quieter jets.

Over the past 35 years or so there has been a clear
correlation between the growth of finance, as a share of the
economy, and weaker growth in productivity, the measure of how
much we create given the resources we put in. While the study
looks at data from 15 advanced economies, the US experience is
a good illustration. Profits from the financial sector now run
at about 20 percent of the whole, about double the level from
World War II to the 1970s. By one measure, productivity since
1970 has grown at less than half the 1945-1969 rate, implying a
massive shortfall in growth.

That growth in finance has been a drag on productivity,
according to the study, while also distorting how resources are
invested and what comes out the other end.

Where skilled labor 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 RD-intensive
industries, Stephen Cecchetti of Brandeis University and Enisse
Kharroubi of the BIS write.

Amazing, if not surprising, then, is the way in which the
finance industry has attracted and maintained subsidies. Finance
benefits massively from the tax-deductibility of debt and
through direct and indirect means because of government support
in times of stress.

Maintaining these and other subsidies through lobbying and
other kinds of suasion is certainly part of how the scads of
clever people drawn into the financial industry are deployed.

At the center of the problem seems to be the way in which an
overdeveloped financial sector seems to distort the allocation
of resources.


In part this is because finance, by its nature, will tend to
favor projects with lots of collateral to claim back if things
go wrong but with lower prospective results if successful. Real
estate development is a good example. Real estate features land
and houses to be pledged against loans, making it appear a safer
bet than backing the Apple or Tesla of tomorrow. Housing, and
other low-productivity sectors, usually win out, according to
the study.

This may help to explain why construction-driven booms, like
the sub-prime bubble, are often associated with rapid growth in
finance. Taking talent into account can magnify the effect, with
bankers getting better at making loans and reclaiming collateral
but entrepreneurs having less incentive to swing for the fences
and hire the best.

Better, in other words, if you are an entrepreneur to gamble
with borrowed money while hiring brick-layers than employing
Harvard-trained physicists in an aerospace project. That
physicist, as we saw in the last boom, becomes a financial
engineer instead.

The implication to this pattern, as it is played out across
an economy over a long period, is that more and more resources
are dedicated to lower-yield projects and fewer to higher-payoff

The study estimates that a sector with a high research and
development requirement with the bad luck to be in a country
whose financial system is growing rapidly will grow 1.9 to 2.9
percentage points a year slower than one with low RD needs in a
country with a slow-growing financial sector.

And this is all before we consider the ways in which the
finance sector is gamed by its workers to their own advantage.
Medical research and aerospace offer far fewer ways for workers
to exploit their own greater understanding of the field than
that of their bosses. Bankers and fund managers are forever
claiming to have come up with superior products and strategies
which only blow up some time later, often after the designer has
pocketed a fortune and left the building.

Observing this state of play, even demonstrating that it is
happening, is not enough.

The real struggle has to come in designing regulation that,
gently but firmly, shrinks the financial sector, preferably

There was a time, from the imposition of Glass-Steagall
banking legislation in 1933 to the 1970s, when banking was
boring and its practitioners a bit dull.

Our wealth, health and wellbeing may depend on driving the
brilliant out of banking.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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