Finance: Research, Policy and Anecdotes

I had the pleasure of discussing two excellent papers at the 1st Finance and productivity conference at the EBRD this week, on the role of finance in fostering or impeding entrepreneurship. Christoph Albert and Andrea Caggese use survey data from the Global Entrepreneurship Monitor for 21 OECD countries over the period 2002 to 2013 and show that GDP and financial sector shocks hurt the establishment of new enterprises, especially of high-growth enterprises, providing convincing evidence that financing constraints are especially binding for transformational, potentially high-growth entrepreneurs.   Nandini Gupta and Isaac Hamaco, on the other hand, document a drain brain from manufacturing into the financial sector in the US. Specifically, engineering graduates between 1998 and 2006 are more likely to work in financial sector if they start out in an area with a higher share (and thus higher growth) of financial sector employment or study in a state that deregulates interstate banking. This, in turn, results in relatively fewer start-ups founded by engineering graduates that go into finance, as well as less innovation and less VC funding by such start-ups.

Together, these papers add evidence to two strands of the macro-finance literature that have developed somewhat parallel – on the one hand, the importance of alleviating financing constraints to foster entrepreneurship and thus ultimately improve resource allocation and increase productivity growth; on the other hand, the unhealthy growth of the financial sector, extracting rents from the real economy and drawing talent away from the manufacturing sector. Both papers thus relate to the decline in start-ups (as documented for the US in this Economic Policy paper, which also shows that it is not related to higher federal regulation) and the slow-down in productivity growth. But what to make of the seeming contradiction – financing constraints vs. brain drain?  Well, these findings are consistent with an important role of financial intermediation for economic growth (which works through productivity growth and thus entrepreneurship), but also with a growth-impeding effect of an oversized financial system that does not necessarily focus on intermediation anymore. It is thus consistent with tentative results that Hans Degryse, Christiane Kneer and I documented  - financial intermediation helps growth in the long-run, while an indicator gauging the size of the financial sector (e.g., employment share) results in higher short-term growth, but higher growth volatility in the long-term. These findings are also consistent with work by Christiane Kneer who documented a brain drain, looking specifically at the US – industries with higher financing needs benefit from a larger financial sector, while industries with a higher share of R&D and skilled workers actually loose. In summary, efficient financial services are important for the real sector, while an oversized financial system is not necessarily and might even be damaging for the real sector.

Overview