Friday, April 8, 2011

Kauffman Foundation: Consequences of Financialization

The Kauffman Foundation recently published a paper on the consequences of financialization and financial sector growth.

Financialization & Its Entrepreneurial Consequences

The paper, written by Paul Kedrosky and Dane Stangler, is a thoughtful look at financial sector excesses and the economic damage done yet doesn't vilify:

...there should be no question that the financial services sector plays a key role for entrepreneurs. It helps reduce moral hazard, while mitigating adverse selection problems that otherwise might exist for young companies that lack long track records or significant collateral. To pretend otherwise—to pretend that we can have widespread entrepreneurial capitalism in the absence of a significant and active financial services sector—is to be fanciful.

The problems start when the financial sector gets large and begins to feed back on the sector itself (as it did during the 2008 financial crisis) instead of supporting the "real" economy.

Consequences of this include the misallocation of human and financial capital among other things.

Some background. With the exception of the peak years leading up to the great depression, the financial sector had rarely occupied more than 4% of GDP in the U.S. That started to change in the 1980s. Over the past 30 years the financial has grown substantially peaking at nearly 9% of GDP right before our most recent crisis.

According to the report it now accounts for 8.3% of GDP.

The U.S. financial sector’s rise to relative economic importance is historically unprecedented. Even during the peak years leading up to the Great Depression, the U.S. financial services industry never rose above 6 percent of GDP, a figure that took until 1990 for it to regain. 

A few other notable excerpts:

The Talent Drain
...most of the industry’s profits come from the creation, sales, and trading of complex products, like the collateralized debt obligations (CDOs) that played a central role in the recent financial crisis. These new products require significant financial engineering, often entailing the recruitment of master's- and doctoral-level new graduates of science, engineering, math, and physics programs. Their talents have made them well-suited to the design of these complex instruments, in return for which they often make starting salaries five times or more what their salaries would have been had they stayed in their own fields and pursued employment with more tangible societal benefits. 

The Capital Misallocating Process
Capital, including human capital, flows to the opportunities with the highest risk-adjusted returns, but those opportunities' perceived merits are subject to distortions. Regulations can change capital allocations, as can feed processes. In the latter case, capital can begin to feed on itself, with higher asset prices inducing more investments, and thus generating still higher prices, a misallocating process that continually feeds on itself—until it stops, often unhappily and expensively.

Consequences of Capital Misallocation
What are the consequences of capital misallocation? Fundamentally, it means that capital—both human and financial—is being inefficiently allocated in the economy, with the result being that some sectors and opportunities are being starved, relatively speaking, while other sectors see a flood of capital, potentially producing a positive feedback cycle that exacerbates one or both of the preceding effects. In particular, capital misallocation can lead to inflated (deflated) asset prices, lower productivity, less innovation, less entrepreneurship, and, thereby, lowered job creation and overall economic growth. The mechanism that creates each of these effects is, of course, the flow of capital in the economy as exacerbated and distorted by financialization.

Here's a related post written by Vivek Wadwa with the title: Friends Don't Let Friend Get into Finance. Wadwa left the corporate world to teach engineering students back in 2005. From his post:

I was shocked—and upset—when the majority of my students became investment bankers or management consultants after they graduated. Hardly any became engineers. Why would they, when they had huge student loans, and Goldman Sachs was offering them twice as much as engineering companies did?

The Kauffman Foundation paper goes on to consider the effects of these distortions on entrepreneurship in the United States.

Well worth reading.

Adam

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