Both a lack of finance and a bloated financial sector. Both? Really?

At Stumbling and Mumbling, The Trade Deal Fetish. Chris Dillow writes:

As for what it is that is holding back exports, there are countless candidates – the same ones that help explain the UK’s relative industrial weakness: poor management; a lack of vocational training; lack of finance or entrepreneurship; the diversion of talent from manufacturing to a bloated financial sector; the legacy of an overvalued exchange rate. And so on.

If we were serious about wanting to revive UK exports, we would be discussing what to do about issues such as these.

In the one paragraph we have "countless candidates" that could have caused the problem. In the next, they are no longer candidates but issues and we should be "discussing what to do" about them. That's not my style.

I would want to figure out which of the "candidates" perhaps contribute to holding back exports, and which is the driving force that created the problem in the first place. Because if you never solve the original problem, you never solve the problem. And the more you change other things, the wrong things, in your attempt to fix the problem, the more you change the economy. And the more you change the economy like that, because of a problem you can't seem to solve, the less chance you'll ever have of making things better. But that's just me.

That's not why I'm writing today. I'm writing today because Dillow's list of candidates includes both "lack of finance" and "a bloated financial sector". Both? Really?

Dillow identifies the problem with finance as "the diversion of talent". I've seen the "talent" story before; it makes me want to puke. Apparently, finance is bloated with talent and somehow this is a problem. Why doesn't supply-and-demand fix that problem, I want to ask. If there is a shortage of talent in manufacturing (or elsewhere), why don't offers of better pay solve that problem? And if finance is bloated with people of talent, why do those people still get paid so damn much? Why doesn't pay for talent fall, if finance has too many talented people? The "diversion of talent" to finance is nonsense; it's not the problem.

I suppose the problem could be economic policies that boost the financial sector. Such policies skew the operation of supply and demand. Yes, I would go with this explanation. Of course, it means policy's favoritism of finance must come to an end. And it may mean, if finance could become dominant naturally and not only by the encouragement of policy, it may mean that policy would have to suppress finance a bit, always and forever. (Heaven forbid. I know.)

But if finance really is the problem that undermines UK export growth, then we must ask what is the problem with finance. The problem is obvious, but people seem not to want to see it: The problem with finance is cost.

In domestic markets, the financial sector absorbs income that would otherwise go toward spending that increases aggregate demand. The growth of finance (or let's say the excessive growth of finance) reduces aggregate demand. It slows output growth, job growth, and the improvement of living standards. Furthermore, if the solution to the problem of reduced aggregate demand is found in the growth of household debt, then the solution contributes to further expansion of the financial sector and is ultimately self-defeating. But these are domestic issues, unrelated to the growth of trade.

The cost of finance is one of the costs that must be counted when the costs of production are tallied. Other things equal, a large or "bloated" financial sector will generate more cost than a small financial sector. The cost of output will be higher in the economy with bloated finance, and its products will be less competitive in international markets.

Perhaps a comparison of financial sector sizes of the UK and Germany would help to clarify this issue. As a crude measure, consider finance as a share of GDP: 6.9% in the UK versus almost 4% in Germany. That's a difference of about 3% of GDP. Here's the crude part: If you think of finance as a cost rather than a product, you can estimate that prices of UK products are maybe 3% higher that German products, solely because of financial cost.

It would be better to compare private sector financial liabilities, if you have the data.