If the financial sector gets too big or grows too fast, it's bad for growth:
Finance is great, but it can be a real drag, too: When we were college students in the mid-1970s, some of our friends wanted to change the world and our understanding of it. They worked on things like galactic structures, superconductors, computer algorithms, subcellular mechanisms, and genetic coding. Their work aimed at providing cheap energy, improving information technology, curing cancer, and generally making our lives and our appreciation of the world around us better.
By the 1990s, attitudes had changed. Many top students, including newly-minted Ph.D.s, moved from natural science and engineering to finance. Their goal was to get high-paying jobs.
Would we be better off today if some of these financial wizards had focused instead on inventing more efficient solar cells or finding ways to forestall dementia? The older we get, the more we think so (especially when it comes to dementia). And, believe it or not, there is now notable, cross-country evidence buttressing this view.
For the past few years, one of us (Steve) has been studying the relationship between economic growth and finance. The results are striking. They come in two categories. First, the financial system can get too big – to the point where it drags productivity growth down. And second, the financial system can grow too fast, diminishing its contribution to economic growth and welfare.
Just to get this on the record: we really like finance. Without efficient financial services, there would be no prosperous economies today. Intermediaries and financial markets both mobilize and channel savings to those who can use capital most productively; they also allocate risk to those persons who are most able to bear it. Despite its recently tarnished reputation, financial innovation greatly improves people’s lives (see here). As a result, when finance is properly harnessed, it makes economies more productive, enhancing employment and growth, and makes the world a better place.
So, we badly need efficient finance. But how much do we really need? And, should we be concerned if financial sector growth sharply outpaces the growth in the rest of the economy? ...
After answering these questions, explaining the results, and discussing how finance can lower growth, they conclude:
... Many observers (especially the largest financial intermediaries themselves) are critical of the increased regulation of the financial sector following the crisis of 2007-2009, arguing that it will slow economic growth. We, too, can think of some misdirected regulatory efforts that may diminish long-run efficiency without reducing systemic risk (see, for example, our take on raising the maximum loan-to-value ratio for mortgages to 97%).
But, we strongly support the authorities’ efforts to raise capital requirements in order to make the financial system safer. If anything, the research on finance and economic growth strengthens that view, suggesting that there will be little, if any, cost in terms of economic growth even if further increases in capital requirements were to lead to some shrinkage of the size of the financial sector in the advanced economies.