Is the Finance Sector Too Big?

We’ve heard a lot of talk about whether the crisis in Greece or Spain or Italy could affect us in the United States.  Well, just a few weeks ago, Stephen Cecchetti, the Head of the BIS’ Monetary and Economic Department, gave a speech titled, “Is Globalisation Great?”  (Remember…the BIS is the central bank of the word’s central banks.)  I thought that this was an interesting speech because (while he didn’t discuss this specific issue), it’s a short leap to conclude that this potential contagion effect is what he was referring to.   Here’s a summary of his comments, followed by two simple thoughts:

1. Financial development creates value by promoting the efficient allocation of capital.

2. Globalization also creates value because it allows all of us to benefit from those who have a comparative advantage in providing goods and services.

3. While financial development creates value, there comes a point at which it starts to cause problems.  His research shows that financial development creates value until this sector’s employment becomes greater than 3.2% of total employment.  (In the U.S. (based on 2008 data), he measured our financial sector employment at 4.1% — approximately 30% too high.)

4. The problems caused by this growth include: (A) inefficient allocation of capital (too much capital chasing few opportunities); (B) the fragility of the economic system when lending stops (the transition from too much capital to too little capital); and (C) the misuse of scarce resources (too many of our best and brightest want to go into banking or managing hedge funds).

5. Globalization can also cause problems because we have a few large banks that dominate international lending and those banks have large exposures to many countries.

6. The result is that balance sheet linkages between countries can be large (and can be indirect due to these banks).  When one country has problems, these large banks could turn off the spigot and impact many other countries.

Two Thoughts

1. In the past, I’ve frequently described my belief that we over-allocate human resources to the financial sector.  I see many of our best and brightest headed to this sector, rather than starting new businesses.  (I train the students who want to go into asset management.)

2. So many people have commented that our exports to Europe are a small enough part of our GDP that another European recession (that has started) shouldn’t push the U.S. into recession.  That’s probably true.  But, if European recession causes too many loan defaults or eventually pushes countries to leave the EU, we’re going to see a contagion effect that will have a huge impact on the U.S.  We have enough recent experience to understand that our economy doesn’t do well when bank lending slows.

Have a great week.

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