August 22, 2014

Troubleshooting: Finance and Innovation

Hester Peirce

Former Senior Research Fellow
Summary

While the precise nature of the link between financialization and innovation remains elusive, a healthy financial sector clearly can play an important role in fostering innovation.

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The 2007–08 financial crisis reinvigorated calls for shrinking and simplifying the U.S. financial sector. The financial industry, which includes the banking, insurance, and securities sectors, made up 8.2 percent of the economy in 2006 and still accounted for 7.9 percent of gross domestic product in 2012. That is up from 6.5 percent in 1992. The cynic sees the financial sector in its current form as unproductive, or even counterproductive, serving only to steal our brightest college graduates, corrupt their idealism with tantalizing bonuses based on frenzied yet empty trading, and make them bringers of destruction to the main streets and back roads of the American Dream.

The financial crisis rightly inspired some soul-searching about the function and dysfunction of the U.S. financial sector. But we ought to proceed with caution before joining the chorus condemning the financial industry’s pure villainy, or making meat-axe assertions about its ideal (smaller) size. Finance is a key ingredient in innovation, and innovation is a factor of unparalleled importance for the economy as a whole. Changes to the financial system affect whether, how, when, and where innovation happens, so we must take care to ensure that efforts to shrink the financial industry do not also shrink innovation in the overall economy.

A study of the relationship between innovation and finance cannot yield a definitive formula for determining the proper size of the financial sector. As Martin Baily and Douglas Elliott point out, that is a fool’s errand:

It is extremely hard to determine the right size of the financial system based on well-grounded economic theories. In truth, it is very difficult to judge the right size of almost any industry and attempts at the use of central planning and other mechanisms to correct assumed problems of this nature have usually failed.1

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