Early theoretical analysis regarding the direction of the relationship between the financial system and economic growth was mixed. To Hicks(1969) the financial system was critical to the industrialisation of England and to Schumpeter(1912) a well-functioning banking sector was fundamental to technological innovation. On the other hand, Robinson(1952) declared that “enterprise leads and finance follows”, while Lucas(1988) saw economists “badly over-stress(ing)” the role of financial factors in economic growth. Empirical analysis starts with Goldsmith(1969) who found a positive relationship between financial and economic development. Notwithstanding several studies critical of Goldsmith his main conclusion was maintained(e.g. King and Levine, 1993; Gertler and Rose, 1994; Roubini and Sala-I-martin, 1992). In a 1997 review paper Levine concluded that “the preponderance of theoretical reasoning and empirical evidence suggests a positive, first-order relationship between financial development and economic growth.”
By 1997, the financial sector in most developed countries, was already in a sharp growth phase when measured by almost every relevant metric. In the US its share of GDP grew from 2.8% in 1950 to 4.9% in 1980 to 8.3% in 2006 (Greenwood and Scharfstein, 2013), while according to the NBER its share of total corporate profits grew from 14% in 1980 to almost 40% by 2003. Philippon and Reshef(2013) found that salaries in financial services were comparable to other industries until 1980 but are now on average 70% more than in other industries. This growth in the size and the salaries of the finance sector is referred to as ‘the financialisation of the economy.’ The first to really question whether this has been for the betterment of the economy was Rajan (2005) who suggested it was causing economies to be more risky. Later,(Rajan 2010) he argued that the propensity of the system to reward risk-taking would result in the economy proceeding from bubble to bubble.
Since the mid-2000s, more studies have questioned whether the growth of the financial system has worked to the betterment of anybody other than those in the industry. In perhaps the most telling study, Cecchetti and Kharroubi(2012), (2013) confirm that the development of the financial system is critical for economic growth in developing economies but that “big and fast growing financial sectors can be very costly for the rest of the economy . . . draw(ing) essential resources in a way that is detrimental to growth at the aggregate level”. Talented people are perhaps the most crucial of the essential resources so drawn away. As the former UK Minister Peter Mandelson argued, “We need more real engineers and fewer financial engineers.” Orthangazi(2008) found a negative relationship between financialisation and real investment which he put down to the latter being crowded out by the increasing size and profitability of financial investment. Beck(2013) is led to similar conclusions, while even the Governor Australia’s Central Bank, Glenn Stevens(2010) has questioned “whether all this growth (in finance) was actually a good idea; maybe finance had become too big (and too risky).” More explicitly ISA(2013) questions the efficiency of the Australian financial sector by measuring the extent of capital formation attributable to finance. In 1990 for every dollar of labour and capital deployed in the financial sector about $3.50 of capital formation could be attributed to the sector. By 2012 that had collapsed to $1.50.
A number of researchers have examined the putative benefits of financialisation. Philippon(2013) finds that despite technological advances unit costs in financial services have increased over the last three decades and are higher now than they were in 1900. Philippon, Bai and Savov(2013) examined whether the much greater spending on price discovery has resulted in “better” prices and improved allocative efficiency. They found that despite a four-fold increase in expenditure and a large decrease in the costs of information processing, there is no evidence that pricing has become more informationally efficient. Similarly, Malkiel(2013) found that despite US fund management fees rising 141 times between 1980 and 2010, there has been no improvement in pricing in equity markets nor evidence that it has translated into value added for clients. Other deleterious impacts of financialisation include increasing distortions in income distribution(Bakija, Cole and Heim, 2010), Piketty(2014) and the exacerbation of agency costs in corporations(Krippner, 2005).
We leave the last word to Adair Turner who sees “no clear evidence that the growth in the scale and complexity of the financial system in the rich developed world over the last 20 to 30 years has driven increased growth or stability.” We encourage the FSI to ponder the evidence that financial systems in developed economies have grown beyond the point where they make a positive contribution to economic growth or to those they are presumed to serve. It would be a bad starting point to presume that the Australian financial system is currently doing a good job.