Academic studies: Too Much Finance


A large and growing body of academic research supports the finance curse analysis: academics have been calling it the “Too Much Finance” (TMF) literature.  The general TMF thesis is as a financial sector grows it helps economies — but only up to a certain point, after which it turns bad. The Finance Curse analysis overlaps with the TMF literature but is much broader, investigating the multiple political, economic, cultural, democratic and social effects that oversized finance can have on a country, using a cross-disciplinary approach.

(Click to enlarge)

With zero finance, little more than subsistence farming is possible. The TMF literature shows that as finance develops, it helps an economy to become more sophisticated, channelling savings to productive investments and providing other useful services, and helping to create wealth. But after a certain point growth in finance starts to inflict damage, as profitable techniques to extract wealth from other parts of the economy begin to overpower traditional financial activities that support the creation of wealth.  This graph, from the IMF, illustrates one aspect of the trend.

It has been known for many years that large financial sectors can generate grave problems for the countries that host them. Adam Smith, Karl Marx and John Maynard Keynes all warned of the perils of too much finance, and the wrong kind of finance. The economist Hyman Minsky in 1974, and Charles Kindleberger in 1978, building on older traditions, explained how too much finance generates economic crises. Charles Tobin in 1984, described how oversized financial systems could cause resources to be misallocated in an economy. More recently, Raghuram Rajan in 2005, in a paper that was widely attacked at the time, argued that letting finance grow too large posed risks of a financial meltdown. Very soon, his words would prove prophetic.

After the crisis, and especially since 2012, a new set of studies has emerged, all showing essentially the same inverted u-shaped relationship between finance and growth. Many of these are outlined below: a  longer list is provided at the bottom of Overcharged, a 2016 study by Gerald Epstein and Juan Montecino of the impacts that an oversized financial sector has had on the US economy. For studies estimating the numerical costs of “Too Much Finance” on particular countries, notably the UK and the US, see our Big Numbers page.

It should be noted that these estimates generally seek to calculate the costs of oversized finance in terms of lost economic output. The finance curse inflicts damage in many other areas, which are often unmeasurable — such as damage to democracy and to the rule of law. So the damage is likely to be greater than these studies suggest.


Selected articles and papers


The UK’s Finance Curse? Costs and Processes
Andrew Baker, Gerald Epstein and Juan Montecino, SPERI, 2018 (live at 00.01 GMT on Friday, Oct 5.) 

Building on Epstein’s and Montecino’s 2016 paper Overcharged (which estimates the damage to the US economy inflicted by an oversized financial sector,) this report will calculate the damage inflicted on the UK, in terms of lost GDP accumulated over 1995-2015 due to finance being too big, compared to what GDP would have been had finance been its optimal size.

(This report is flagged in the Finance Curse book (p278, footnote 12) with a slightly different title:  Baker, A., Epstein, J., Leaver, A., Montecino, J., Fields, D. and Atkinson, R., ‘The UK’s Finance Curse? Costs, Processes and Future Research Agendas’, Sheffield Political Economy Research Institute Working Paper, 2018.”  This paper is still forthcoming: the headline for now is the SPERI report by Baker, Epstein and Montecino.)  


The role of institutions in finance curse: Evidence from international data
Siong Hook Law, Ali M.Kutan, N.A.M.Naseem, Journal of Comparative Economics, 2018

Looking at the effect of banking sector development on economic growth in a panel of 87 countries. It finds that “The marginal effect of financial development on economic growth is statistically significant [and] too much financial development tends to retard economic growth.” And effective institutions can improve outcomes.


Non-linearities in the Relationship between Finance and Growth
Ugo Panizza, Graduate Institute of International and Development Studies, Geneva, 2017

Exploring criticisms of the “too much finance” / Finance Curse strand in the literature, specifically rebutting a report by William Cline of the Peterson Institute for International Economics, which argues that the “too  much finance” results are just spurious statistical correlations. “There is convincing evidence of an inverted U-shaped relationship between financial depth and economic growth. However, there is no consensus on the drivers of this result.” [NB Cline has served as Chief Economist of the Institute of International Finance, a pro-finance lobby group.]


The Finance Curse: Britain and the World Economy
John Christensen, Nick Shaxson, Duncan Wigan, The British Journal of Politics and International Relations, Jan 5, 2016

The first academic outing of the finance curse concept. Building on an earlier document laying out the thesis for the first time, written by John Christensen and Nicholas Shaxson for the Tax Justice Network.


Epstein and Montecino, 2016

In Overcharged: the High Cost of High Finance, Gerald Epstein, Professor of Economics at the University of Massachusetts, Amherst, and Juan Antonio Montecino, also at Massachusetts, Amherst, estimate the costs to the U.S. economy of the financial sector growing above its optimal size and beyond its healthy functions. They estimate

  1. One aspect of the damage

    Rents, or excess profits;

  2. Misallocation costs, or the price of diverting resources away from non-financial activities;
  3. The costs of the 2008 financial crisis.

They check for possible “double counting” between these three dimensions and conclude: “Adding these together, we estimate that the financial system will impose an excess cost of as much as $22.7 trillion between 1990 and 2023, making finance in its current form a net drag on the American economy.”

Watch Prof. Epstein discuss his research at Sheffield University in November 2017.


Why Does Financial Sector Growth Crowd Out Real Economic Growth?”
Cecchetti, Stephen G. and E. Kharroubi. 2015, BIS Working Paper, No. 490, 2015

Building on their earlier work (see below.) “An increase in finance reduces total factor productivity growth. . . where skilled labour works in finance, the financial sector grows more quickly at the expense of the real economy. Financial growth disproportionately harms financially dependent and R&D-intensive industries.”


Labour reallocation and productivity dynamics: financial causes, real consequences
Claudio Borio, Enisse Kharroubi, Christian Upper and Fabrizio Zampolli

Looking at a sample of 21 advanced economies over forty years, they produce two key findings. First, credit booms tend to undermine productivity growth by inducing labour to be reallocated towards lower productivity-growth sectors – such as a temporarily bloated construction sector. Second, the impact of reallocations that occur during a boom, and during economic expansions more generally, is much larger if a crisis follows. In other words, when economic conditions become more hostile, misallocations beget misallocations.

Finance and economic growth in OECD and G20 countries
Boris Cournède, Oliver Denk, OECD Working Paper 1223, 2015

The paper shows that financial development benefits growth – up to a point, after which it becomes harmful. It points to five factors that link more credit to slower growth: i) excessive financial deregulation, ii) a more pronounced increase in credit issuance by banks than other intermediaries, iii) too-big-to-fail guarantees by the public authorities for large financial institutions, iv) a lower quality of credit and v) a disproportionate rise of household compared with business credit. By contrast, expansions in stock market funding in general boost growth.


Rethinking Financial Deepening: Stability and Growth in Emerging Markets
Ratna Sahay and co-authors, 2015

This IMF discussion note looks at the effects of financial sector growth on emerging markets / developing countries. It finds that most of these countries’ financial sectors are small, with outstanding private credit to the economy averaging 50 percent of GDP, which is roughly half the growth-maximising level in the TMF literature. So further growth in finance seems to enhance economic growth. But there are diminishing returns. “The effect of financial development on economic growth is bell-shaped: it weakens at higher levels of financial development.”


Does too much finance harm economic growth?
Siong Hook Law and Nirvikar Singh, Journal of Banking & Finance, 2014

They study 87 developed and developing countries. “The empirical results indicate that there is a threshold effect in the finance–growth relationship. In particular, we find that the level of financial development is beneficial to growth only up to a certain threshold; beyond the threshold level further development of finance tends to adversely affect growth. These findings reveal that more finance is not necessarily good for economic growth and highlight that an “optimal” level of financial development is more crucial in facilitating growth.”


Too Much Finance?
Jean-Louis Arcand, Enrico Berkes and Ugo Panizza, IMF, 2012

“This paper examines whether there is a threshold above which financial development no longer has a positive effect on economic growth. We use different empirical approaches to show that there can indeed be “too much” finance. In particular, our results suggest that finance starts having a negative effect on output growth when credit to the private sector reaches 100% of GDP.”


Reassessing the impact of Finance on growth.
Cecchetti, S. and E. Kharroubi, BIS Working Paper Series #381, 2012

“With finance you can have too much of a good thing. That is, at low levels, a larger financial system goes hand in hand with higher productivity growth. But there comes a point – one that many advanced economies passed long ago – where more banking and more credit are associated with lower growth.”  They also look at how growth in a financial system – measured as growth in either employment or value added – impacts real productivity growth. “We find evidence that is unambiguous: faster growth in finance is bad for aggregate real growth.”

“Finance literally bids rocket scientists away from the satellite industry. The result is that erstwhile scientists, people who in another age dreamt of curing cancer or flying to Mars, today dream of becoming hedge fund managers.”


The $100 billion question
Comments by Mr Andrew G Haldane, Executive Director, Financial Stability, Bank of England, at the Institute of Regulation & Risk, Hong Kong, 30 March 2010.

The costs of a financial crisis go far beyond the immediate bailout costs: it can also damage output across an economy. Haldane’s paper looks at the value of output losses for the world and the UK, assuming different fractions of the 2009 loss are permanent – 100%, 50% and 25%. “These losses are multiples of the static costs, lying anywhere between one and five times annual GDP. Put in money terms, that is an output loss equivalent to between $60 trillion and $200 trillion for the world economy and between £1.8 trillion and £7.4 trillion for the UK. As Nobel-prize winning physicist Richard Feynman observed, to call these numbers “astronomical” would be to do astronomy a disservice: there are only hundreds of billions of stars in the galaxy.” (See also Haldane’s 2010 speech The contribution of the financial sector – miracle or mirage?)