Are Hedge Funds and Finance Bad for Growth?

Many hedge funds have enough trouble these days explaining lackluster results to their investors. But a new study takes a broader swipe at the industry, claiming that hedge funds — and a generally oversized financial sector — are bad for growth.

A growing financial sector can fuel productivity growth in developing economies, but beyond a certain point — “one that many advanced economies passed long ago” — more finance tends to reduce growth, says the research paper, entitled “Reassessing the impact of finance on growth.”

Why? The study cites two reasons. First, excessive credit growth can leave economies hamstrung by debt, something that seems all too obvious in today’s deleveraging world. Second, a large financial sector tends to drain capital and skilled labor away from other sectors of the economy.

“Finance literally bids rocket scientists away from the satellite industry,” write the paper’s authors, Stephen Cecchetti and Enisse Kharroubi. “The result is that people who might have become scientists, who in another age dreamt of curing cancer or flying to Mars, today dream of becoming hedge fund managers.”

The critique comes not from the Occupy Wall Street movement but from a bastion of the financial establishment: Cecchetti is the chief economist of the Bank for International Settlements, and Kharroubi is a staff economist there. The study’s findings provide intellectual support for tighter financial regulation, which the Basel-based BIS has sought to promote through its affiliate, the Basel Committee on Banking Supervision, and the Financial Stability Board, whose secretariat is housed at the BIS.

The study draws on data from 50 countries between 1980 and 2009. It finds that credit growth has tended to foster stronger productivity growth until credit reaches a level around 100 percent of gross domestic product, then has acted as a drag on productivity growth. For countries that rely primarily on bank credit, which includes most of Europe, the credit turning point comes a bit lower, at around 90 percent of GDP.

Using a different metric, the study finds that productivity growth tends to diminish when employment in the financial sector hits 3.9 percent of the overall work force. Canada, Ireland, Switzerland and the U.S. had more than 4 percent of their work forces employed in finance between 2005 and 2009, while Australia was right at 3.9 percent and the U.K. just below that level.

The crisis has dealt a blow to the idea that what’s good for Wall Street is good for Main Street. Still, banks have lobbied aggressively against a raft of new regulations, arguing that higher capital requirements and tighter constraints on trading activities will restrict the flow of credit.

The new BIS study suggests that wouldn’t be a bad thing. It’s also the latest in a number of recent studies that seek to debunk the precrisis consensus that more developed financial systems are inherently good for growth.

Economists at the IMF last year published a paper, “Too much finance?”, which claimed that countries tended to grow more slowly when credit reached 80 to 100 percent of GDP. Raghuram Rajan, then chief economist of the IMF, set off a stir at the Federal Reserve’s annual Jackson Hole Conference back in 2005 by presenting a paper, “Has financial development made the world riskier?” that clashed with the prevailing market orthodoxy of then–Fed chairman Alan Greenspan.

Back in the mid 1980s, when the financial boom was still in its early days, James Tobin, the late Nobel laureate in economics, wrote that the financial sector was attracting talented young workers “into activities that generate high private rewards disproportionate to their social productivity.” That view, of course, led him to propose imposing a levy on financial transactions, since dubbed a Tobin tax.

With its possibility of riches, finance has been attracting talent — and criticism — since time immemorial. Cecchetti’s word will hardly be the last. But with Western economies looking as fragile as ever more than five years after the crisis, it’s hard to argue with his conclusion that “there is a pressing need to reassess the relationship of finance and real growth in modern economic systems.”