A very interesting relationship from the excerpt of the article:
“What is behind this empirical regularity? What is the mechanism by which finance, something we know to be fundamental to the operation of the economy, is doing harm? Our hypothesis is that it arises because finance tends to favour relatively low productivity industries as such industries usually own assets that are relatively easy to pledge as collateral. So as finance grows, the sectoral composition of the economy changes in a way that drives aggregate total factor productivity down. The intuition for this comes from the observation that it is easier to obtain external finance for projects that are based either use tangible capital in their production or produce more tangible outputs. The more tangible a firm’s assets or output, the easier it is to pledge them as collateral for a loan.
We take this prediction to the data and study 33 manufacturing industries in 15 advanced economies. The key to figuring out which sectors are most likely to be damaged from financial sector growth requires that we look for the sectors where pledging of either assets or output is difficult. On the asset side, we can measure this directly from information on asset tangibility. For output, we use research and development intensity as a proxy.
Our results are unambiguous. When the financial sector grows more quickly, productivity tends to grow disproportionately slower in industries with lower asset tangibility, or in industries with higher research and development intensity.
As for the quantitative implications of these estimates, we find that productivity of an industry with high asset tangibility located in a country experiencing a financial boom tends to grow 2.5-3% a year more quickly than an industry with low asset tangibility located in a country not experiencing such a boom. This is quite a large effect, especially when compared with the unconditional sample mean and volatility of labour productivity growth of 2.1% and 4.3%, respectively.
Financial booms are not, in general, growth-enhancing. And, the distributional nature of the impact is disturbing, as credit booms harm what we normally think of as the engines for growth – those industries that have either lower asset tangibility or high research and development intensity. 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.”
Why growth in finance is a drag on the real economy
If financing depends on the eligibility of collateral pledging, then won’t growth be biased towards capital intensive industries? The incentive of the financial sector, given their low risk appetite, is principal security first and return second, no matter how boring the return is. Because of this, they would only finance proven industries, thus reinforcing the status quo. Industries with higher value in the future, the ones indicated with higher research and development intensity, tend to be passed over for financing activities. In short, finance encourage “more of the same” economic growth.
That is why the aggregate economic growth declines because more growth are attributed to lower-productivity sectors (which happen to be the ones easier to receive financing due to higher asset tangibility) than the higher-productivity research-driven sectors.
We have to explore for ways to stimulate more economic growth. Maybe I should read The Entrepreneurial State. The book explore the ideas that innovation happens because of state funding, which socialized the cost of research while allowing individuals and firms to privatized the rewards. Incentive design like this is important because higher growth through research are fundamentally riskier.