The Financial Sector is Too Big

By Philip Arestis Professor and Director of Research at the Cambridge Centre for Economic & Public Policy and Senior Fellow in the Department of Land Economy at the University of Cambridge, UK, and Professor of Economics at the University of the Basque Country and Malcolm Sawyer, Professor of Economics, University of Leeds. Originally published at Triple Crisis

Has the financial sector become too large, absorbing too many resources, and enhancing instabilities? A look at the recent evidence on the relationship between the size of the financial sector and growth.

There has been a long history of the idea that a developing financial sector (emphasis on banks and stock markets) fosters economic growth. Going back to the work of authors such as Schumpeter, Robinson, and more recently, McKinnon, etc., there have been debates on financial liberalisation and the related issue of whether what was relevant to financial liberalisation, namely financial development, “caused” economic development, or whether economic development led to a greater demand for financial services and thereby financial development.

The general thrust of the empirical evidence collected over a number of decades suggested that there was indeed a positive relationship between the size and scale of the financial sector (often measured by the size of the banking system as reflected in ratio of bank deposits to GDP, and the size of the stock market capitalisation) and the pace of economic growth. Indeed, there have been discussion on whether the banking sector or the stock market capitalisation is a more influential factor on economic growth. The empirical evidence drew on time series, cross section, and panel econometric investigations. To even briefly summarise the empirical evidence on all these aspects is not possible here. In addition, the question of the direction of causation still remains an unresolved issue.

The processes of financialisation over the past few decades have involved the growing economic, political and social importance of the financial sector. In size terms, the financial sector has generally grown rapidly in most countries, whether viewed in terms of the size of bank deposits, stock market valuations, or more significantly in the growth of financial products, securitisation, and derivatives as well as trading volume in them. This growth of the financial sector uses resources, often of highly trained personnel, and inevitably raises the question of whether those resources are being put to good use. This is well summarised by Vanguard Group founder John Bogle, who suggests, “The job of finance is to provide capital to companies. We do it to the tune of $250 billion a year in IPOs and secondary offerings. What else do we do? We encourage investors to trade about $32 trillion a year. So the way I calculate it, 99% of what we do in this industry is people trading with one another, with a gain only to the middleman. It’s a waste of resources” (MarketWatch, Aug. 1 2015).

Financial liberalisation and de-regulation were promoted as ways of releasing the power of the financial sector, promoting development of financial markets and financial deepening. The claims were often made by the mainstream that financial liberalisation had removed “financial repression” and stimulated growth. Yet, financial liberalisation in a country often led to banking and financial crises, many times with devastating effects on employment and living standards. Financial crises have become much more frequent since the 1970s in comparison with the “golden age” of the 1950s and 1960s. The international financial crisis of 2007/2008 and the subsequent Great Recession were the recent and spectacular crises (though the scale of previous crises such as the East Asian ones of 1997 should not be overlooked). The larger scale of the financial sector in the industrialised countries has been accompanied (even before 2007) with somewhat lower growth than hitherto. As the quote above suggests there has not been an upsurge of savings and investment, and indeed many would suggest that the processes of financialisation dampen the pressures to invest, particularly in research and development. Has the financial sector become too large, absorbing too many resources, and enhancing instabilities?

An interesting recent development has been a spate of research papers coming from international organisations and many others, which have pointed in the direction that indeed the financial sector in industrialised countries have become too big—at least when viewed in terms of its impact on economic growth. (See Sawyer, “Financialisation, financial structures, economic performance and employment,” FESSUD Working Paper Series No. 93, for a broad survey on finance and economic performance.) These studies rely on econometric (time series) estimation and hence cover the past few decades—which suggests that their findings are not in any way generated by the financial crisis of 2007/2008 and the Great Recession that followed.

A Bank of International Settlements study concluded that “the complex real effects of financial development and come to two important conclusions. First, financial sector size has an inverted U-shaped effect on productivity growth. That is, there comes a point where further enlargement of the financial system can reduce real growth. Second, financial sector growth is found to be a drag on productivity growth.” Cournède, Denk,and Hoeller (2015) state that “finance is a vital ingredient for economic growth, but there can also be too much of it.” Sahay, et al. (2015) find a positive relationship between financial development (as measured by their “comprehensive index”) and growth, but “the marginal returns to growth from further financial development diminish at high levels of financial development―that is, there is a significant, bell-shaped, relationship between financial development and growth. A similar non-linear relationship arises for economic stability. The effects of financial development on growth and stability show that there are tradeoffs, since at some point the costs outweigh the benefits.”

There are many reasons for thinking that the financial sector has become too large. Its growth in recent decades has not been associated with facilitating savings and encouraging investment. It has absorbed valuable resources which are largely engaged in the trading in casino-like activities. The lax systems of regulation have made financial crises more likely. Indeed, and following the international financial crisis of 2007/2008 and the great recession a number of proposals have been put forward to avoid similar crises. To this day, nonetheless, the implementation of these proposals is very slow indeed (see, also, Arestis, “Main and Contributory Causes of the Recent Financial Crisis and Economic Policy Implications,” for more details).

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  1. MartyH

    Now that Michael Hudson’s Killing the Host has been available for a while, one suspects a Picketty-like effect with folks “discovering” that Taibbi’s Giant Vampire Squid characterization of Goldman-Sachs (one of many) wasn’t funny.

  2. susan the other

    This is a great and readable essay. Sure sounds like Minsky. And even Larry Summers when he advocates for more bubbles. And Wolfgang Schaeuble said repeatedly that “we are overbanked.” We just don’t know how to do it any other way. When everything crashes it’s too late to regulate. Unless Larry knows a clever way to regulate bubbles.

    1. JTMcPhee

      The Banksters’ refrain:

      “Don’t regulate you,
      Don’t regulate me!
      Regulate that guy over behind that tree…”

      MY scam is systemically important!

    2. Just Ice

      “We just don’t know how to do it any other way. “ STO

      Yet there is another way, an equitable way :) Dr. Michael Hudson himself says that industry should be financed with equity, not debt.

      1. susan the other

        Hudson is right. So is Bogle who says the stock market’s purpose is to supply needed capital for businesses to grow, etc. But since TINA and trickle down and corporate raiding and now flat-out austerity there is no equity being created even by selling equity (which is how it should be) because traders, and now high-speeders, are taking the equity out as fast as credit is infusing it.

        1. Just Ice

          Why share when those with equity can legally steal?

          And we wonder why we have gross wealth inequality?

    3. Leonard

      There is way to manage bubbles before they get out of control. This article explains how. Go to

  3. ben

    Wasted resources are way higher than the Vanguard example. They misdirect resources especially into land and issue new money as debt.

    1. RepubAnon

      They think that they make their living by “ripping the eyes out of the muppets” – so they’re opposed to regulations which would protect the muppets’ eyes.

      I look at the financial industry as sort of like sugar for the economy – the right amount is good for you, but too much will kill you.

  4. Just Ice

    “The lax systems of regulation have made financial crises more likely.”

    Actually, it’s the near unlimited ability of the banks to create deposits (“loans create deposits” but also debts) that causes large scale financial crises. And what is the source of this absurd ability of the banks? ans: government privileges including deposit insurance instead of a Postal Savings Service or equivalent and a fiat (the publics’ money) lender of last resort.

    Besides, regulations typically do not address the fundamental injustice of government subsidized banks – extending the publics’ credit to private interests.

    1. Synoia

      There is something very wrong about money creation from loans. I’m not arguing that this is incorrect,

      I’m looking at money creation being a burden on the citizenry. I cannot see how this will end well, because of the asymmetric nature, money creation only benefits the banks, of the burden of money creation.

      1. Just Ice

        “There is something very wrong about money creation from loans.”

        More precisely, there is something very wrong about being driven into debt by government-subsidized private credit creation. Source of the rat race? Look no further.

        1. zapster

          It’s the bank-money vs. government money situation. The hysteria over “The Deficit (gasp)” insures that none of us have cash and must borrow to live. The bankers won.

          1. Just Ice

            “It’s the bank-money vs. government money situation.” zapster

            More precisely, who gets to create the government’s money since it is taxation* that drives the value of fiat.

            But it’s an absurd situation since obviously the government ALONE should create fiat, not a central bank for the benefit of banks and other private interests, especially the wealthy.

            As for the private sector, let it create its own money solutions and my bet is that we’ll have a much more equitable (pun intended) society as a result.

            The problem then is taxation. How does one tax someone’s income in Bitcoins, for example? How does one preclude tax evasion? Unavoidable taxes such as land taxes (except for a homestead exemption) are one possibility.

            *As well as the need to pay the interest on the debt the government subsidized banking cartel drives us into.

            1. Yves Smith Post author

              *Sigh*. The government alone does control the money supply in a fiat currency issuer. The government hasn’t bothered to do so actively because the only time it DID try doing that (under Reagan and Thatcher) they found out, contra Friedman, that money supply growth bore no relationship to any macroeconomic variable. Monetarism was a failed experiment.

              1. Just Ice

                “The government alone does control the money supply in a fiat currency issuer. “ Yves Smith

                Then what are Open Market Purchases? And what is quantitative easing? And what are currency swaps? And the discount window? Whence the new fiat for all of the above? The US Treasury acting for the general welfare or the central bank acting for the welfare of the banks and the rich?

                As for Monetarism, of course it failed since the banking system as a whole is not reserved constrained because :

                1) government deposit insurance and the lack of a Postal Savings Service mean newly created deposits have no real place to go OUTSIDE the banking system since physical cash is no real alternative to government insured deposits and transactions.

                2) if the banking system as a whole were short of reserves the Fed would provide them as necessary from the discount window and/or open market purchases to keep interest rates down.

                So no, the US Government does not even control its fiat supply, much less the total money supply.

                PS: I don’t argue for monetarism but for 100% private banks with 100% voluntary depositors. Of course you’ll say that free banking has been tried and failed but not so since we’ve never had a proper Postal Savings Service or equivalent. Hence the US population has always been largely at the mercy of private banks.

                1. Just Ice


                  Who cares if 100% private banks with 100% voluntary depositors can’t survive? Is the private sector so stupid it can’t create endogenous money supplies that don’t require government privileges?

      2. readerOfTeaLeaves

        I happened upon a great link — about the probable origins of interest.
        Here’s the link:
        Scroll down to “The Idea of Interest”

        This author posits that back in the (ancient, herding) day, people lent cattle. I lend you my cow, your bull impregnates her, and I get a part of the calf.

        What the author probably didn’t understand, but is known to those of us interested in the history of metallurgy, is that there was a belief that metals ‘grew’ — after all, plants grew from the ground, vines grew from the ground, trees and bushes also grew from the ground. It was not a great stretch to suppose that metals also grew within the ground, and back in those ancient days they expected the same kind of ‘growth’ from metals that happened with agricultural products.

        Perhaps if I ever get to retire, I can read Hudson’s entire work, and possibly he covers this topic. But I do think that it is time for the rest of us to rethink the nature of money — particularly in an emerging digital era.

        1. cnchal

          Thanks for that link. Here is a little nugget that relates to today.

          The legal limit on interest rates for loans of silver was 20% over much of Dumuzi-gamil’s life, but Marc Van De Mieroop demonstrates how Dumuzi-gamil and other lenders got around such strictures — they simply charged the legal limit for shorter and shorter term loans! Curiously, while mathematics during this era was extraordinarily advanced, the government failed to understand, or at least effectively regulate the close link between time and money.

          Sound familiar. It’s more like the banksters regulate government.

          As for compound interest, it seems to be the most diabolical human invention yet, as it infers exponential growth without limits.

          Here is Keynes discussing compound interest in his speech “Economic Possibilities for our Grandchildren” (1930)

          From the earliest times of which we have record – back say to two thousand years before Christ – down to the beginning of the eighteenth century, there was no very great change in the standard of life of the average man living in the civilized centres of the earth. Ups and downs certainly. Visitations of plague, famine, and war. Golden intervals. But no progressive, violent change. Some periods perhaps 50 per cent better than others – at the utmost 100 per cent better – in the four thousand years which ended (say) in A.D. 1700.

          This slow rate of progress, or lack of progress, was due to two reasons – to the remarkable absence of important technical improvements and to the failure of capital to accumulate.

          The absence of important technical inventions between the prehistoric age and comparatively modern times is truly remarkable. Almost everything which really matters and which the world possessed at the commencement of the modern age was already known to man at the dawn of history. Language, fire, the same domestic animals which we have today, wheat, barley, the vine and the olive, the plough, the wheel, the oar, the sail, leather, linen and cloth, bricks and pots, gold and silver, copper, tin, and lead – and iron was added to the list before 1000 B.C. – banking, statecraft, mathematics, astronomy, and religion. There is no record of when we first possessed these things.

          At some epoch before the dawn of history – perhaps even in one of the comfortable intervals before the last ice age – there must have been an era of progress and invention comparable to that in which we live today. But through the greater part of recorded history there was nothing of the kind.
          The modern age opened, I think, with the accumulation of capital which began in the sixteenth century. I believe – for reasons with which I must not encumber the present argument – that this was initially due to the rise of prices, and the profits to which that led, which resulted from the treasure of gold and silver which Spain brought from the New World into the Old. From that time until today the power of accumulation by compound interest, which seems to have been sleeping for many generations, was reborn and renewed its strength. And the power of compound interest over two hundred years is such as to stagger the imagination.

          Let me give in illustration of this a sum which I have worked out. The value of Great Britain’s foreign investments today is estimated at about £4,000 million. This yields us an income at the rate of about 6 1/2 per cent. Half of this we bring home and enjoy; the other half, namely, 3 1/2 per cent, we leave to accumulate abroad at compound interest. Something of this sort has now been going on for about 250 years.

          For I trace the beginnings of British foreign investment to the treasure which Drake stole from Spain in 1580. In that year he returned to England bringing with him the prodigious spoils of the Golden Hind. Queen Elizabeth was a considerable shareholder in the syndicate which had financed the expedition. Out of her share she paid off the whole of England’s foreign debt, balanced her budget, and found herself with about £40,000 in hand. This she invested in the Levant Company – which prospered. Out of the profits of the Levant Company, the East India Company was founded; and the profits of this great enterprise were the foundation of England’s subsequent foreign investment. Now it happens that £40,000 accumulating at 3 1/2 per cent compound interest approximately corresponds to the actual volume of England’s foreign investments at various dates, and would actually amount today to the total of £4,000 million which I have already quoted as being what our foreign investments now are. Thus, every £1 which Drake brought home in 1580 has now become £100,000. Such is the power of compound interest !

          From the sixteenth century, with a cumulative crescendo after the eighteenth, the great age of science and technical inventions began, which since the beginning of the nineteenth century has been in full flood – coal, steam, electricity, petrol, steel, rubber, cotton, the chemical industries, automatic machinery and the methods of mass production, wireless, printing, Newton, Darwin, and Einstein, and thousands of other things and men too famous and familiar to catalogue.

          What is the result? In spite of an enormous growth in the population of the world, which it has been necessary to equip with houses and machines, the average standard of life in Europe and the United States has been raised, I think, about fourfold. The growth of capital has been on a scale which is far beyond a hundred-fold of what any previous age had known. And from now on we need not expect so great an increase of population.

          This reminds me of the huge fortunes growing at compound interest today.

          Take the Gates Foundation as an example.

          From Wikipedia: It had an endowment of US$42.3 billion as of 24 November 2014.

          If this were to grow at a compound interest rate of 7.2% annually, it would double every ten years, and in one hundred years would be $43 trillion dollars and in two hundred years $44,354 trillion or $44.354 quadrillion. It’s as if Bill and Warren are playing a practical joke on the world, as their compound interest monster swallows every available dollar.

          I wonder what a loaf of bread will cost in two hundred years?

    2. nigelk

      Fractional-reserve banking is anathema to human dignity itself.

      What was it Gandhi said about “wealth without work”…?

  5. griffen

    Top heavy might be the marginally better angle to take here. Although I recently left the state (N Texas, Dallas), Texas banks are being merged or acquired left and right. On some occasions it is necessary if very small institutions are unable to compete, unable to meet a decent ROE bogey (6.0% ROE is sorta low), or just unable to fend off progress.

    Other occasions the larger regional and national banks can just win on scale.

  6. Noni Mausa

    I have long thought about the banking system as a beating heart. Of course it needs fuel, like the rest of the body, but when a heart gets larger and larger, and contains more and more blood, and uses more and more fuel, the rest of the body never fares well.

    “Surging bank profits” is never a headline that makes me happy.

  7. anders

    The real question is: why was it that the “creation of wealth” had to turn to the financial sector. IMHO it’s because the productive sector is lesser and lesser able to produce surplus value. So that free capital istn’t attracted to it. Of course in the financial sector there isn’t any value created at all.

    1. Just Ice

      ” IMHO it’s because the productive sector is lesser and lesser able to produce surplus value. “

      Yes, because of unjust wealth distribution; the host has finally been exhausted. With meta-materials, nano-technology, genetic engineering, better catalysts, etc. and with practical nuclear fusion on the horizon (because of new superconducting materials) mankind has probably never been on the verge of creating so much value as now but can’t because of lack of effective demand, not for junk but for such things as proper medical and dental care while the wealthy have more than they know what to do with.

  8. blert

    Is the sky blue ?

    Decades of ‘political – solvency’ insurance has permitted ‘the blob’ to overwhelm all.


    If all of society played Poker … would anything be produced ?

    THAT’S the aspect that has metastasized.

    It’s not proper to term it the ‘financial sector’ — gambling// speculation emporium… now you’re talking.

    When the government chronically intervenes to bail out highly sophisticated fools….

    Jon Corzine is the result. — And he’s not even the target of law enforcement !!!!

  9. sd

    Financial liberalisation and de-regulation were promoted as ways of releasing the power of the financial sector, promoting development of financial markets and financial deepening.

    Release the Kraken comes to mind.

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