Governments seem to be enamoured with financial markets, judging by the support they give them around the world to encourage their growth. The assumption seems to be that there’s always a positive relationship between the size of the financial system and its contribution to the economy.
This assumption that bigger is always better is one that Australia’s financial system inquiry would do well to test as it considers “how the financial system could be positioned to best meet Australia’s evolving needs and support Australian economic growth”.
Among the questions that could be asked are whether the growth of the financial system has worked to the betterment of anybody other than those working in the industry – the answer to which is, perhaps not.
Therefore the starting point for the inquiry, led by former Commonwealth Bank of Australia chief David Murray, should be to evaluate the current state of Australia’s financial system and to focus on how it can be made “leaner and keener”.
Early analysis of a link between the growth of the financial system – something now referred to as “financialisation” – and economic growth was mixed, but by the mid-90s it was accepted that there was a positive correlation between financial development and economic growth.
In the two decades since then, however, there has been unprecedented growth in the financial sector, both in terms of size and in the remuneration of those working within the industry and questions have begun to be asked about whether this financialisation has been to the betterment of anyone other than those working in the industry.
In the United States, the sector’s share of GDP grew from 4.9% in 1980 to 8.3% in 2006, while its share of total corporate profits grew from 14% in 1980 to 40% by 2003.
As for the size of the finance sector in Australia, the Bank of International Settlements estimates it now accounts for 11.5% of total “value add” in the national economy, a figure that has doubled since the mid-1980s.
This compares with the 2008 peak of 7.7% in the US and 10.4% in Ireland – and of course we all know what happened to those economies. The BIS researchers believe 6.5% may be the point where the financial system’s size “turns from good to bad”.
This growth in size of the financial sector has been matched by the growth in remuneration of those working in the sector. Until the 1980s, salaries in the financial services industry were comparable to those in other industries, but now the average salaries of those working in finance in the US are on average 70% more than those in other industries.
It was in 2005 that Raghuram Rajan – then chief economist at the International Monetary Fund but now Governor of the Reserve Bank of India – first publicly posed the question of whether economies were actually benefiting from financialisation. He suggested the development of the financial system was in reality causing economies to be more risky.
Rajan was dismissed at the time, but subsequent events suggest closer attention should have been paid to what he was saying.
A number of studies since then have added to the concerning picture he began to paint. Perhaps the most telling study, published in 2012, found that the large and fast growing financial sectors in developed economies were having a clear, negative impact on productivity and economic growth.
Other research has concluded there is a negative relationship as “real” investment is crowded out by the increasing size and profitability of financial investment.
Even in Australia, Reserve Bank Governor Glenn Stevens has pondered “whether all this growth (in finance) was actually a good idea; maybe finance had become too big (and too risky).” Similarly Andy Haldane from the Bank of England has questioned the financial sector’s economic contribution, pointing to “its ability to both invigorate and incapacitate large parts of the non-financial economy”.
Efficient, or just big?
What of the supposed benefits of the growth in financial markets? It could be expected that larger markets would mean lower unit costs for financial services, as happens with efficiencies of scale in other industries. Instead, it seems unit costs have actually increased over the last three decades and are higher now than they were in 1900.
Researchers such as Thomas Philippon of Stern Business School have also examined whether financialisation has resulted in “better” pricing and therefore more efficient allocation of capital.
They found that despite a four-fold increase in spending on “price discovery” and a large decrease in the costs of information processing, there is absolutely no evidence that pricing in markets is more informed. Despite US funds management fees rising 141 times between 1980 and 2010, there is no evidence of an improvement in pricing in equity markets or of added value for clients.
The bulk of the submissions to Australia’s financial system inquiry, like this one from the Australian Bankers’ Association, will undoubtedly seek opportunities for further growth and greater subsidies for the financial sector.
Who is more likely to be heard? Economics writer Ross Gittins fears the financial institutions will win out, especially with the inquiry being chaired by someone who led an institution that benefited so greatly from the financialisation of the Australian economy, and who has a history of opposing what is not in the direct interests of these institutions (like removing the four pillars policy and a levy on banks).
The fear is that the starting premise for the inquiry will be that everything is fine and more is better.