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Too Big to Grow

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Summary

The Bank of International Settlements (BIS) recently released a new report analysing the relationship between the growth of the financial sector and productivity growth. The empirical findings are particularly worrying. The BIS economists estimate that in countries experiencing rapid growth in their financial sector, financially-dependent industries experience 2.5% lower productivity growth than in countries with slower growing financial sector. To put that into perspective, the OECD average of productivity growth was 1.6% during 2009-12. Clearly, this is a disturbing finding for any economic policy-maker. What do the BIS findings tell us are the appropriate macroeconomic policy settings for productivity growth? What does this mean governments can actually do? And what does it mean in terms of winners and losers in an economy?

What is Productivity Growth?

Productivity is an efficiency measure, it is how much economic value is produced per unit of input. Essentially, it is a ratio of output to input. The higher it is, the more efficient the economy. In the case of the BIS research, they use the ratio of GDP per worker.

Productivity growth is how much faster output grows relative to inputs. It measures how much more efficient an economy becomes. It should be noted, while I am using the economy as a unit of measurement, productivity can be measured at the industry and smaller levels.

Productivity and Economic Growth

Economists consider productivity growth to be a key driver of economic growth. It is not the only driver but it is considered to be of ‘higher quality’. This means it can lead to self-sustaining economic growth. For example, improvements in early childhood education could lead to a more capable and innovative workforce in the future. In contrast, fuelling a housing bubble through debt produces narrow benefits for speculators. Most economists would argue for economic reforms that are ‘productivity-enhancing’ and generate broad benefits rather than policies that would benefit specific vested interests.

The Finance Sector and Productivity

The BIS economists presents controversial evidence that a fast growing financial sector can actually harm productivity and therefore economic growth. This runs against the conventional wisdom that presumes that the financial sector is an engine for many economies. Certainly, up to a certain size, the financial sector can have a positive effect on an economy. However, when it grows beyond this threshold (3.9% of GDP), the financial sector starts to compete for smart people in other industries. You probably have heard of aerospace engineers who left NASA to become quantitative analysts at Goldman Sachs – this is what happens. So, industries that rely on smart people (e.g. aerospace, biotech) may not be able to grow as fast because they lack the expertise. Not only that, but a larger financial sector reinforces the risk-averse attitudes of large financial institutions. This results in less investment for risky and productivity-enhancing technology firms and more investment for safer investments such as property or construction which have little productivity benefits for the wider economy. So, essentially a large and fast-growing finance sector results in lower productivity and economic growth by shifting human and financial resources to ‘sure bets’ such as property.

What can Governments Do to Stimulate Productivity Growth?

Many governments in recent times have relied on reducing the costs of debt so that the finance sector is able to lend to businesses at cheaper rates. The findings by the BIS economists suggests that this is exactly the kind of policy that would lead to the financial sector ‘crowding out’ the innovative, productivity-enhancing sectors. Remember, a faster growing finance sector attracts resources from other sectors. So while some cheaper debt becomes available, it doesn’t necessarily find its way to productivity-enhancing sectors. In fact, it may repeat the mistakes of previous economic busts by re-inflating a housing bubble.

So what can governments do? One of the findings in the BIS paper is that productivity-growth is higher for financially-dependent industries when monetary policy is tighter. In other words, higher interest rates actually make high debt industries more efficient. This sounds counter-intuitive because surely firms facing higher interest costs wouldn’t invest in productivity-enhancing technologies? That may be the case, but there are other ways to improve productivity such as becoming smarter about your processes, how you manage your workers and tightening your supply chain to reduce wastage. So a higher interest cost may force companies to look to other parts of the business to reduce costs in order to become more efficient. This means that a government seeking to improve the productivity of debt-dependent industries should reinforce the anti-inflationary bias of their Central Banks.

What about promoting productivity in R&D-intensive industries? How do we get them to produce more innovations and employ more smart people? The BIS economists found that productivity growth of R&D-intensive industries is associated with tighter fiscal policies (i.e. budget surpluses) and higher trade and current balances. This leads to a number of policy implications. First, tighter fiscal policies imply lower government expenditure relative to tax revenue. The paper wasn’t specific on what type of spending should be reduced. But we do know that certain policies designed to instil confidence in the finance sector (e.g. deposit guarantees) or reduce the costs of debt (e.g. negative gearing) are designed to help the finance sector grow. Unfortunately, they also impose costs on governments and ultimately tax-payers. For example, the Dallas Federal Reserve estimated that the 2007-09 Great Recession cost the US Government $US12-13 trillion or 80-85% of the US GDP in 2007.

Second, higher trade and current balances implies the country exports more than it imports (higher trade balance) or it receives more income from foreign operations (higher current balances). A higher trade balance can be achieved in a number of ways. It could be achieved through trade protection – this could provide a stable environment for long-term investments in innovative industries which may be attractive to banks. Or it could be achieved through a competitive export sector either because their exports are cheaper (e.g. China) or because they are of higher quality and value (e.g. Germany). Unfortunately, the BIS paper does not provide an answer on which trade policies would enhance productivity in R&D-intensive industries. For higher current balances, this implies that domestic companies have significant foreign operations to the extent that income received from foreigners is greater than income paid to foreigners for their domestic operations. So a country like Australia, with persistent current account deficits is a country with significant foreign ownership of the economy is not conducive for investment in R&D-intensive industries. It is unclear why greater foreign ownership would deter investments in innovative industries. Maybe because firms prefer to have R&D assets closer to head office? Again, the BIS paper doesn’t unpack this issue.

As insightful as the BIS paper was, it leaves a lot of policy questions unanswered. It would be fascinating to read future research into this area.

Will Productivity-enhancing Policies be Politically Feasible?

This is a hard question to answer since it depends on specific circumstances and the political system. However, it is clear that the finance sector would be a lower from productivity-enhancing policies. In developed economies, the finance sector is well-organised and can effectively fight any reform that is contrary to their interests. However, they may be opposed by industries that would benefit from productivity-enhancing policies. But not all policies are necessarily zero-sum in nature. For example, export-enhancing policies could benefit both the finance and innovative sector. I hasten to add, this should be consistent with WTO obligations. So, the political feasibility of any productivity-enhancing reforms would depend on many factors, not least the skill of the reformer in crafting an agreement that could secure support.