The Impact of Financialization on Economic Growth and the Austrian Business Cycle

Great stuff from the Bank of International International Settlements (BIS), where they come up with a study on the diminishing returns from the financial sector.

Stephen G Cecchetti and Enisse Kharroubi of the BIS concludes, (bold emphasis mine)

In this paper, we study 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. Our interpretation is that because the financial sector competes with the rest of the economy for scarce resources, financial booms are not, in general, growth enhancing. This evidence, together with recent experience during the financial crisis, leads us to conclude that there is a pressing need to reassess the relationship of finance and real growth in modern economic systems. More finance is definitely not always better

In my view this BIS study exhibits tight relevance to, if not provides proof of the Austrian Business Cycle theory (ABCT)…

From the great Professor Murray N. Rothbard [Economic Depressions: Their Causes and Cure] (bold my comments)

The Ricardian analysis of the business cycle went something as follows: The natural moneys emerging as such on the world free market are useful commodities, generally gold and silver. If money were confined simply to these commodities, then the economy would work in the aggregate as it does in particular markets: a smooth adjustment of supply and demand, and therefore no cycles of boom and bust. But the injection of bank credit adds another crucial and disruptive element. For the banks expand credit and therefore bank money in the form of notes or deposits which are theoretically redeemable on demand in gold, but in practice clearly are not…

The banks, then, happily begin to expand credit, for the more they expand credit the greater will be their profits. This results in the expansion of the money supply within a country, say England. As the supply of paper and bank money in England increases, the money incomes and expenditures of Englishmen rise, and the increased money bids up prices of English goods. The result is inflation and a boom within the country.

But this inflationary boom, while it proceeds on its merry way, sows the seeds of its own demise. For as English money supply and incomes increase, Englishmen proceed to purchase more goods from abroad. Furthermore, as English prices go up, English goods begin to lose their competitiveness with the products of other countries which have not inflated, or have been inflating to a lesser degree. Englishmen begin to buy less at home and more abroad, while foreigners buy less in England and more at home; the result is a deficit in the English balance of payments, with English exports falling sharply behind imports. But if imports exceed exports, this means that money must flow out of England to foreign countries. And what money will this be? Surely not English bank notes or deposits, for Frenchmen or Germans or Italians have little or no interest in keeping their funds locked up in English banks. These foreigners will therefore take their bank notes and deposits and present them to the English banks for redemption in gold — and gold will be the type of money that will tend to flow persistently out of the country as the English inflation proceeds on its way. But this means that English bank credit money will be, more and more, pyramiding on top of a dwindling gold base in the English bank vaults. As the boom proceeds, our hypothetical bank will expand its warehouse receipts issued from, say 2,500 ounces to 4,000 ounces, while its gold base dwindles to, say, 800. As this process intensifies, the banks will eventually become frightened. For the banks, after all, are obligated to redeem their liabilities in cash, and their cash is flowing out rapidly as their liabilities pile up. Hence, the banks will eventually lose their nerve, stop their credit expansion, and in order to save themselves, contract their bank loans outstanding. Often, this retreat is precipitated by bankrupting runs on the banks touched off by the public, who had also been getting increasingly nervous about the ever more shaky condition of the nation's banks.

The bank contraction reverses the economic picture; contraction and bust follow boom. The banks pull in their horns, and businesses suffer as the pressure mounts for debt repayment and contraction. The fall in the supply of bank money, in turn, leads to a general fall in English prices. As money supply and incomes fall, and English prices collapse, English goods become relatively more attractive in terms of foreign products, and the balance of payments reverses itself, with exports exceeding imports. As gold flows into the country, and as bank money contracts on top of an expanding gold base, the condition of the banks becomes much sounder. [the boom is followed by a bust which extrapolates to the financial sector size has having an inverted U-shaped effect on productivity growth. Boom initially drives up productivity and eventually contracts when the bust appears, hence the U-shape effect—my comment].

This, then, is the meaning of the depression phase of the business cycle. Note that it is a phase that comes out of, and inevitably comes out of, the preceding expansionary boom. It is the preceding inflation that makes the depression phase necessary. We can see, for example, that the depression is the process by which the market economy adjusts, throws off the excesses and distortions of the previous inflationary boom, and reestablishes a sound economic condition. The depression is the unpleasant but necessary reaction to the distortions and excesses of the previous boom. [the boom which is followed by a bust shows that “financial sector growth is found to be a drag on productivity growth”. Whatever temporary gains acquired from the boom are lost through capital consumption thus “financial booms are not, in general, growth enhancing”—my comment]