Over the last three decades the US financial sector has grown six times faster than nominal GDP. This paper argues that there comes a point when the financial sector has a negative effect on growth – that is, when credit to the private sector exceeds 110% of GDP. It shows that, of the advanced countries currently suffering in the fallout of the global crisis were all above this threshold, above which financial development no longer has a positive effect on economic growth. We develop a simple model in which the expectation of a bailout may lead to a financial sector which is too large with respect to the social optimum. We then use different empirical approaches to show that there can indeed be “too much” finance. We conclude by showing that the size of the financial sector was a significant amplifying factor in the global crisis that followed the collapse of Lehman Brothers in September 2008.
“..we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity“. James Tobin