Big finance is a problem, not an industry to be nurtured; To bring down our debt levels, we cannot avoid shrinking the financial sector

November 3, 2013 5:23 pm

Big finance is a problem, not an industry to be nurtured

By Dirk Bezemer

To bring down our debt levels, we cannot avoid shrinking the financial sector, says Dirk Bezemer

Many western economies have both large financial sectors and exorbitant private debt-to-output ratios. This is no coincidence. Each loan is a debt, so a large financial sector implies high debt levels. For example, in the mid-1980s, loans by UK banks to UK companies and households were less than a quarter of gross domestic product; today they amount to 130 per cent. Add non-bank borrowing to that, and total private debt today stands at well over twice UK GDP.Debt is not all bad; borrowing is good for growth if loans are used productively, so that both the debt and the GDP grow. This is financially sustainable. Problems arise when debt grows beyond the rate of GDP growth. This typically happens because of lending to property and other asset markets, rather than for production of goods and services. In the UK, the relative volumes of home mortgages and of lending to property and financial businesses have tripled since 1990 to a level of 98 per cent of GDP, up from 33 per cent in 1990. Lending to non-financial business was 25 per cent of GDP in 1990 – as it is now.

Textbooks depict bank credit as the economy’s lubricant. The reality is starkly different. British banks lend four times more to the mortgage and financial markets than to British business. Things are no different in other overbanked economies such as the US, Canada, Australia, the Netherlands, Sweden, and Luxembourg. Most bank lending today does not create value-added but volatility and debt burdens. There is simply too much of it, and it is not supporting production of goods and services. Research shows that countries with larger financial sectors have less investment and innovation, more instability and lower growth rates. Let us face it: banks hinder and hurt the economy more than they help it. Economic growth now requires a shrinking financial sector.

Policy makers have yet to embrace this insight. Today’s politicians came of age in the late 1980s and 1990s and they regard a bloated banking sector as normal. Their focus is on supporting banks. Mark Carney, Bank of England governor, last month said that “a vibrant financial sector brings substantial benefits”. He then offered banks easier access to BoE funds if they lack sufficient quality assets as collateral. This is a backstop for finance but a stopgap for the economy.

What the governor did not note was that in the medium term, financial contraction is not an option but the only possible outcome. Banks will run into liquidity problems and lack quality assets. If we respond by bailing them out – or increasing support for them – we are in for long years of near-zero growth and occasional recessions. Paying off this debt overhang will drain the economy of purchasing power. With debt levels this high, the process might easily take a decade and more.

The alternative is to cut down to size both our debt and our banks. The two must necessarily occur in tandem. Banks create debt much as bakers make bread. We cannot reduce our bread consumption and expect all bakers to stay in business. If we want to bring down our debt levels, we cannot avoid shrinking the financial sector. Both bread and debt are valuable to society, but there are costs to overproduction.

If there is a lack of political will, there is no dearth of policies and instruments. Tax breaks on transfers from wealthy baby boomer parents to young families help reduce mortgage burdens, and so rebuild both bank and household balance sheets. Applications of the “Basel” rules could include smaller weights in capital adequacy ratios for loans to small businesses, where most of the employment gains are.

Fiscal incentives can mobilise the large pool of unused savings into productive lending. New investment vehicles paying modest positive real interest rates (say, 3 per cent) should have no problem in collecting savings in today’s markets. There are many growth-friendly projects with real returns well above that – think of healthcare, ageing or transport. Recent research shows that we have been underinvesting in these and other forms of public capital since the 1990s.

The question is how, not if, we will bring down the debt-to-GDP ratio: over long years of spontaneous debt deflation with ultra-low growth and high unemployment, or by a managed contraction of the financial sector relative to our economy.

The writer is an associate professor at the University of Groningen