The review, published in the Journal of Economic Surveys, comprehensively examined the literature and data on the effects of finance in socioeconomic development and on people’s wellbeing. The conclusion is that a well-developed financial system can enhance prosperity, but an excessively large and poorly regulated one can do more harm than good.
In doing so, the study highlights an important distinction between traditional and modern finance.
“Traditional finance includes well-established financial services such as retail banking and insurance, which allows people to borrow against their future income, to buy a house or start a business,” explains lead researcher, Dr Jan Libich.
In contrast, modern finance refers to active asset trading and complex financial innovation. The rapid expansion of modern finance over the past four decades has been coined “financialization” of the economy – a process where financial institutions and markets increase in size and influence.
Dr Libich and his co-author, Dr Liam Lenten (University of Melbourne and Essential Services Commission), found that modern finance has come to dominate traditional finance over time, draining valuable resources from the real economy.
Based on the literature, they show that financialization has led to “an increased cost of financial intermediation, lower productivity, higher unemployment, reduced economic growth, rising inequality, more systemic risk, as well as a greater danger of financial, economic and fiscal crises.”
These crises reinforce the influence of the financial sector over the economy and policymakers. And they amplify a vicious circle of continued financialization with bigger boom-bust cycles and subpar socio-economic outcomes.
“These issues have reared their collective ugly head yet again as recently as March of this year, when three significant U.S. banks (Silicon Valley, Signature and Silvergate) all failed within the space of a week. In the ensuing banking crisis, thousands of jobs and billions of dollars of investors’ funds were lost,” says Dr Libich.
But there are solutions available. “An acknowledgment that the global financial system is broken is a vital first step”, says Dr Libich. One of the key reform areas is international cooperation in designing and implementing a well-functioning global regulation framework, “because more stringent locally imposed controls tend merely to redirect undesirable financial activities elsewhere.”
Removing government guarantees on ‘too-big-to-fail’ financial institutions, introducing global financial transaction taxes, redesigning reimbursement schemes at financial institutions to encourage a longer-term focus, and improving the community’s financial literacy are also identified as important policies that can reverse the excessive financialization trend.
“Without robust global policy action, modern finance runs the risk of remaining a villain in perpetuity”, says Dr Libich. This is because ongoing financialization will make adoption of these reforms even more challenging in the future; due to the financial sector’s growing influence over politicians and regulators. Now is the time to act.”
Read the paper and commentary.