Comment: Richard Vague on Financialization and Economic Development

Richard Vague is Managing Partner of Gabriel Investments and Chairman of The Governor’s Woods Foundation.

In their May 2015 paper titled “Rethinking Financial Deepening: Stability and Growth in Emerging Markets,”  Ratna Sahay et. al have made an important contribution to the literature on financialization and financial deepening.[1]

The authors demonstrate that the impact of “financial development on economic growth weakens at as you reach higher levels of financial development. In fact, there can be ‘too much finance’— that is, instances where the costs of financial deepening outweigh the benefits. Evidence shows that too fast a pace leads to instability.”

Financialization or financial deepening refers primarily to two factors—the increase in the amount of a given country’s banking/lending in ratio to that country’s GDP and the increase in the ratio of stock market capitalization to that country’s GDP. Of these two measures, the amount of lending to GDP is generally the larger, and since GDP is a reasonable proxy for a country’s income, it is in essence a “private-debt-to-income” ratio for that country.

I believe the findings of this paper are pivotal, yet this subject area, which is a key to understanding our current global economic environment, has been a neglected area of inquiry. Our research suggests that a country’s private debt-to-GDP level becomes a drag on growth as it approaches or exceeds 150%. Japan and Europe are suffering stagnant economic growth because they are still shouldering a private debt burden of 166% and 155% to GDP, respectively. U.S. economic growth continues to frustrate forecasters because its 150% private debt to GDP ratio—up 12% from 2000 and 50% from 1980—continues to burden growth. And now China, with a whopping 231% private debt to GDP ratio, is seeing a deceleration of its growth as it continues to amass ever-higher levels of private debt.

As one specific example of how too much debt creates a drag on consumption and growth, take the case of the U.S. mortgage market.  Almost a decade after the crisis,  eight million of the 50 million mortgages in the United States are still underwater. Homeowners who find themselves in this situation simply cannot spend on things like new cars and travel and other items in a way that supports robust growth.

So Sahay, et. al. are hitting a very important economic nail on the head. Nevertheless, I would like to make two modest observations that may be helpful adjuncts to their work and to the question of financialization.

First, a key conclusion of the paper is that when a country is at low and moderate levels of financialization, increasing the level of financialization boosts growth. However, as the financialization in a country reaches higher levels, the benefit of further increases in financialization is diminished. There is even the suggestion that too high a level of financialization will suppress growth.  This observation begs an unaddressed question—why?

I will attempt a brief explanation.

At its heart, GDP roughly equates to the aggregate spending and income of the businesses and households in a country and the private debt of a country is the sum of household and business loans. So to speak about the “private debt to GDP ratio” of a country is essentially the same as speaking about the “private loan to income ratio” of that country. This ratio is the same measure that lenders have long used to help make loan decisions for individuals and businesses. Whether you are applying as an individual or for your business, if your loan-to-income ratio is low, the lender is likely to conclude you have capacity for more debt, and if it is high, the lender will likely conclude that you will struggle to pay your existing loan, much less qualify to take on additional debt.

It follows directly that if a country’s private debt to GDP ratio is low, let’s say 50%, then the households and businesses in that country generally have low loan-to-income ratios. And if a country’s private debt to GDP ratio is high, let’s say 200%, then the households and businesses in that country generally have high debt ratios. Countries where the households and businesses have low debt ratios are in a better position to see a boost in growth from increased private debt. Countries where the households and businesses have high debt ratios are less likely to be able to boost growth through more borrowing, since they have to use more of their income for servicing debt and are less likely to be able to increase borrowing.

Further, our observation is that this increased borrowing occurs disproportionately among smaller and medium sized businesses, and among middle and lower income families. While increased borrowing by these groups initially results in increased spending, it leaves the borrowers with a burden of debt that subsequently constrains spending. A decrease in spending from these groups after they amass this debt is unlikely to be fully offset by increased spending from lenders, who tend to be a highly concentrated group of institutions.

Low interest rates help alleviate the impact of higher debts, but they aren’t as beneficial as some economists assume. First, borrowers generally have to pay principal in addition to interest, and further, most small and medium sized businesses and middle and low income families don’t enjoy actual rates anywhere near as low as published market rates.

In any event, increased financialization or financial deepening means, by definition, that the debt-to-income ratios of that country’s households and businesses are increasing. As with individuals and businesses, when your debt level is moderate or low, you’re okay, but when it’s too high, it can be a problem. I like to refer to this as the paradox of debt.

Which all bring us to my second observation. The authors state that “empirically, establishing causality from finance to economic growth has been a key challenge.” That may well be so. In fact, once, when I made the assertion that finance was a causal factor in economic growth—a driver of growth—one economist responded by telling me that there is simply no evidence to support my contention. Nevertheless, in my everyday experience over 40 years in business as a CEO of three businesses and then as a private equity investor, the majority of the companies I am familiar with depend on debt for growth and expansion. In fact, without debt, most economic activity would grind to a halt. Today, if you want to buy or build an office building or a house, it usually requires a loan. If you want to open a new store or expand a factory, it usually requires a loan.  The list goes on and on.  

In short, debt financing is essential to virtually every aspect of economic activity in today’s economy.   So I would suggest that even if the conventional tools of economic analysis cannot easily establish the causality from finance to economic growth, finance—the making of loans—is nevertheless as central as any other factor in driving economic growth.   And it is as central to burdening economic growth as any other factor when there is too much finance—by which we mean too much debt.