BUSINESS

Large Financial Sector Can Have Negative Impact On Economy: IMF

07/10/2012 05:19 pm ET

That big ol' financial sector you got right there might be hurting you more than it's helping.

You see, just because a country has a large financial sector doesn't mean it will have a healthy economy, three researchers argue in a recent working paper for the International Monetary Fund (h/t ThinkProgress).

It's true that a strong banking industry can help a society expand economically, but the researchers say that only remains true up to a point. Eventually, they claim, you reach a threshold of diminishing returns. Once a country's financial sector swells above a certain size, it becomes associated with "a negative effect on economic growth."

For that reason, they say, their findings suggest "that there are several countries for which smaller financial sectors would actually be desirable."

It's worth noting that the researchers place that tipping point right around the time when the financial sector extends an amount of credit to private industry that's between 80 and 100 percent of the national gross domestic product.

The World Bank estimates that the U.S. financial sector provides a chunk of credit to private businesses and investors that's worth about 165 percent of the national GDP. So, yes, America is definitely in the danger zone.

The IMF paper offers an interesting perspective on a question a lot of people have been asking since the financial crisis: What are banks really good for? And what role should the government play in keeping them in check?

When banks are moving capital around to people and business who need it, they're performing an important social function -- so the common argument goes. But when they're devoting time and resources mainly to augmenting their own profits, that usefulness to the rest of the country becomes less clear.

That's especially true when Wall Street firms accrue their capital by betting against markets and misleading their clients in the process, or when the gulf between bank profits and their productive output means that they're wasting hundreds of billions of dollars a year simply doing what they do.

For their part, the authors of the IMF paper offer some theories as to why a country's financial sector might grow to the point where it does more harm than good. One scenario, they write, involves "the increased probability of large economic crashes" -- a concept that will not be completely foreign to anyone who remembers the events of 2008.

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