Worried couple calculating their finances
The International Monetary Fund established that a rise in household debt substantially increases the risk of a banking crisis © Dreamstime

Too much finance is dangerous. The global financial crisis proved as much to anyone with eyes in their head. But economic research has been catching up and has begun to demonstrate in nuanced ways how financial growth can harm an economy.

In its new Global Financial Stability Report, the International Monetary Fund adds more fuel to the funeral pyre that is the financial industry’s reputation for doing “God’s work”, as Goldman Sachs’s chief Lloyd Blankfein infamously claimed in 2009, a year after the near-collapse of global finance.

The IMF has devoted a chapter (with a blog post summary) to household debt. It establishes statistically what we might have guessed: a rise in household debt can boost economic growth in the short run, but it makes growth three to five years down the line lower than it would otherwise have been. On top of that, it substantially increases the risk of a banking crisis.

Two questions naturally arise. Is this finding credible? And what explains it?

The answer to the first is that it is indeed credible, because it corroborates a number of recent studies on the dangers of financial growth. The IMF itself has previously established that financial development can improve a country’s prosperity in the early stage — a modern economy needs financial services — but when it reaches a certain size, any further development, on average, destroys wealth.

But importantly, not all finance is created alike. The OECD, too, has shown the general finding that beyond a certain point, more finance is economically harmful. But when the researchers separated different forms of finance, they found something fascinating and important: the worst effects come from banking finance and from credit that is extended to households. That backs up the new results from the IMF. (The OECD found that business credit, too, can reduce growth, but not as much as lending to households.)

The effects charted above are large: the cost of too much finance in foregone prosperity and livelihoods at risk is significant. How can this be, especially as the industry itself insists that it helps grow the economy by increasing access to credit?

The answer may be that this is precisely how it harms the economy more broadly. Studies from the Bank for International Settlements point out that financial growth pushes resources into activities that produce assets easily pledged for credit. Those activities, such as house construction, tend to have lower productivity growth. The allocation of labour, too, may be distorted — in part by pulling talented people into finance away from other sectors. Finally, bigger balance sheets can create more instability by amplifying fluctuations in real value underlying the financial claims.

What does all this mean for policy?

First, that governing finance is deeply problematic. Not because we do not know what to do, but because easy credit to households is difficult for politicians to oppose. Worse than that, as Raghuram Rajan has argued, democratic political systems frequently turn to credit expansion as a substitute for creating real prosperity. Without continued growth in household indebtedness (and no better policy alternatives), the modest recovery since the crisis might have been even more disappointing.

Second, at a minimum, policymakers should actively shape the form in which finance is extended: much more equity-type and stock market financing, and much less bank lending, would be a good move.

And third, there is no excuse for not making the financial system safer. The evidence clearly shows that holding investors accountable for losses — through higher equity requirements, consistently enforced bail-in rules and greater tolerance of restructuring — is needed. If that leads to less credit-intensive economies, as financiers often threaten, then so be it. It may even be a bonus.

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  • Look to New Zealand, writes Dag Detter, who argues that a government’s net worth, not debt or deficit measures, is the best health measure of public finances.

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