Financialization in the EU and its consequences

In order to enable finance to remain a driver for innovative and inclusive economic growth, financialization should be contained. Just published the second ISIGrowth Policy Brief

The European Union has become more financialized since the beginning of the century. The increasing financialization has not affected only financial corporations but also non-financial firms, who have significantly increased the share of financial assets in their balance sheets.

This process has been supported by the ideology that financialization has only positive effects on the economy, because it helps a better allocation of resources. However, a growing body of empirical and theoretical evidence seriously challenges this idea. This evidence points instead to some possible negative consequences of financialization.

ISIGrowth’s second Policy Brief highlights these consequences of financialization and suggests some policy measures that could help to contain and counteract its negative effects on innovative activity, inclusive economic growth, inequality and financial instability.

First, excessive financialization depresses economic growth because it implies that a larger fraction of credit might be channeled toward unfruitful investment projects, possibly generating economic crises (e.g. via housing price bubbles). Second, financialization has negative impact on innovation because the separation between actors taking risks from innovation and actors extracting rents from innovation implies lower share of reinvested profits (e.g. via short-termism and share buybacks). Third, financialization contributes to inequality by strengthening top earners’ bargaining power in terms of higher wages and lower taxation, as well as by burdening public budgets with fiscal assistance to financial institutions in time of crisis. Fourth, financialization may lead to financial instability by increasing both the leverage of interconnected financial institutions and the risk of mispricing of large asset classes (e.g. the dynamics of leverage and mispricing of mortgage backed securities in the run of the 2008 financial crisis).

In order to enable finance to remain a driver for innovative and inclusive economic growth, financialization should be contained. To this end, several measures could be taken, including fostering the demand in the real sector; establishing mission-oriented programs; studying the possibility of setting a minimal ratio of lending to the real economy; studying the possibility of setting a maximal level of intra-financial leverage.

 

Download here the Policy Brief

Download here the Policy Brief’s technical appendix