Can Tighter Financial Regulation and a Smaller Financial Sector Increase Economic Growth?

Jul 9, 2012Ugo Panizza

Economists are increasingly using statistics to debunk the age-old belief that economic growth goes hand in hand with a large financial sector. 

For a long time it was simply taken for granted that a large financial sector was beneficial to economic growth. This assumption supported the long period of financial deregulation and weak enforcement that began in the 1970s. Increasingly, economists are using statistical techniques to challenge this view. In the piece below, Ugo Panizza, the international economist who works for UNCTAD, summarizes the analysis he has done to show that a large financial sector is associated with slower economic growth. Links to the detailed papers he and colleagues have done are included at the end of this post. -Jeff Madrick, Director, Rediscovering Government Initiative

---

The financial system acts like the central nervous system of modern market economies. Without a functioning banking and payment system, it would be impossible to manage the complex web of economic relationships that are necessary for a modern decentralized economy. Finance facilitates the exchange of goods and services, allows diversifying and managing risk, and improves capital allocation through the production of information about investment opportunities.

However, there is also a dark side of finance. Hyman Minsky and Charles Kindleberger emphasized the relationship between finance and macroeconomic volatility and wrote extensively about financial instability and financial manias. James Tobin suggested that large financial sector can lead to a misallocation of resources and that "we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity."

A large financial sector could also capture the political process and push for policies that may bring benefits to the sector but not to society at large. This process of political capture is partly driven by campaign contributions but also by the sector's ability to promote a worldview in which what is good for finance is also good for the country. In an influential article on the lobbying power of the U.S. financial industry, former IMF chief economist Simon Johnson suggested that:

The banking-and-securities industry has become one of the top contributors to political campaigns, but at the peak of its influence, it did not have to buy favors the way, for example, the tobacco companies or military contractors might have to. Instead, it benefited from the fact that Washington insiders already believed that large financial institutions and free-flowing capital markets were crucial to America’s position in the world.

The objective of financial regulation is to strike the optimal balance between the risks and opportunities of financial deepening. After the collapse of Lehman Brothers, many observers and policymakers concluded that the process of financial deregulation that started in the 1980s went too far. It is in fact striking that, after 50 years of relative stability, deregulation was accompanied by a wave of banking, stock market, and financial crises. Calls for tighter financial regulation were eventually followed by the Dodd-Frank Wall Street Reform and Consumer Protection Act and by tighter capital standards in the Basel III international regulatory framework for banks.

Not surprisingly, the financial industry was not happy about this rather mild tightening in financial regulation. The Institute of International Finance argued that that tighter capital regulation will have a negative effect on bank profits and lead to a contraction of lending with negative consequences on future GDP growth. Along similar lines, the former chairman of the Federal Reserve, Alan Greenspan, wrote an op-ed in the Financial Times titled “Regulators must risk more, and intervene less,” stating that tighter regulation will lead to the accumulation of "idle resources that are not otherwise engaged in the production of goods and services" and are instead devoted "to fending off once-in-50 or 100-year crises," resulting in an "excess of buffers at the expense of our standards of living"

Greenspan's op-ed was followed by a debate on whether capital buffers are indeed idle resources or, as postulated by the Modigliani-Miller theorem, they have no effect on firms' valuation. To the best of my knowledge, there was no discussion on Greenspan's implicit assumption that larger financial sectors are always good for economic growth and that a reduction in total lending may have a negative effect on future standards of living.

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.

Countries with large financial sectors (the data are for the year 2006):

Source: Arcand, Berkes, and Panizza.

Ugo Panizza is a chief economist with UNCTAD, the United Nations agency dealing with trade, investment, and development, and is a visiting professor at the Geneva Institute.

 

References

Arcand, J.L., Berkes, E., and Panizza U. (2012) “Too Much Finance” IMF Working Paper WP/12/161 http://www.imf.org/external/pubs/ft/wp/2012/wp12161.pdf

Greenspan, A. (2011) "Regulators must risk more, and intervene less," Financial Times, July 26, 2011.

Johnson, S. (2009), "The quiet coup," The Atlantic (May 2009).

Kindleberger, C. P. (1978), Manias, Panics, and Crashes: A History of Financial Crises, Basic Books, New York.

Minsky, H. P., (1974), "The modeling of financial instability: An introduction," in Modelling and Simulation, Vol. 5, Proceedings of the Fifth Annual Pittsburgh Conference, Instruments Society of America, pp. 267—72.

Tobin, J. (1984), "On the efficiency of the financial system," Lloyds Bank Review 153, 1—15. 


This piece draws from a longer article titled “Finance and Economic Development” and published in International Development Policy (http://poldev.revues.org/?lang=en).

Wall Street image via Shutterstock.com.

Share This