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
John Cochrane is even more blunt: “Pronouncing on the socially optimal size is a waste of time.”2 He dares even to wonder if perhaps “not enough social resources are devoted to trading, because information is a public good”, and trading generates information.Clearly, the relationship between the scope of financialization and innovation in the U.S. economy is not about size but function. It is difficult to precisely capture the role that the financial system plays in fostering innovation and economic growth in any advanced economy. But many analysts are trying to get to the bottom of the relationship, and we have before us a wealth of empirical, theoretical, and anecdotal work by economists, historians, and others. More work is needed, but the existing literature at least gives us a sense of the factors at play. Simply seeing the intricacy of the pertinant relationships and the ease with which the balance can be disturbed may help temper calls for a blunt restructuring of the financial sector that might harm innovation. That’s our modest purpose here.At its core, the financial sector is a place where people with ideas can meet people with money, where buyers can meet sellers, where people can borrow against their future income to meet present needs, and where people bearing risks can meet others willing to take on some or all of those risks. The financial system enables investors to put their money to use in a way that simultaneously benefits themselves and the economy as a whole. A business with growth opportunities can find funds to pursue them. A government can borrow to build a new bridge or highway. And importantly, a penniless innovator with a brilliant idea can meet an investor who is long on money but short on practical creativity.The financial industry’s purpose is to provide liquid channels in which money flows from investors to businesses at as low a cost as possible. Along with the money, information flows through the financial markets and sheds light on the likely future prospects of particular investment opportunities, companies, and sectors. When we think of the financial industry, banks may come to mind, and banks do play an important role in holding deposits for households and businesses and making loans to them. But traditional banking services have become a less important component of the U.S. financial sector than in the past. Investors now provide funds directly and indirectly to companies through pension plans, mutual funds, and hedge funds. Financial intermediaries such as brokers bring together people with complementary objectives.To fulfill its function of channeling money to productive uses, the financial industry needs to be outward-looking—always seeking opportunities to meet the financing and risk-mitigating needs of customers in the real economy, including innovators who both need funds and face risks. Has the growth of our financial sector hindered or fostered innovation in this sense?In thinking about this question, it helps to isolate the terms “financialization” and “innovation” from the contexts in which they often reside in contemporary discourse. “Financialization” has been a major discussion topic in recent Marxist literature relating to concerns about the shift of power and profits to the financial class. The term “innovation”, by contrast, has been expropriated by commercial interests to become the stuff of advertising jingles. The Wall Street Journal recently noted an emerging phenomenon: The word “innovation” is popping up everywhere as CEOs and their companies use it to describe everything from peanut butter Pop-Tarts to pet tattoos to beer milkshakes.3 The older, more traditional interpretations of these terms are more appropriate for serious thinking about their relationship. Innovation entails implementing a new or significantly improved product, service, or process. The National Science Foundation notes many different definitions for innovation, “but a common element is the commercialization of something that did not previously exist.”4 Financialization refers to the increasing concentration of resources, including human resources, in the financial industry.Measuring an industry as diverse as the financial industry is difficult. The imperfect measures available reveal a marked financialization wave in the United States starting around 1980. The following chart shows how the value added by the financial services sector makes up an increasing percentage of gross domestic product over time.This growth has prompted questions about the merits of having such a large and increasingly complex financial sector. Raghuram Rajan, who is now the head of India’s Central Bank and appreciates the benefits of the financial development we have experienced, gingerly warned in 2005 that it “may create a greater (albeit still small) probability of a catastrophic meltdown.”5 The financial crisis dramatically underscored Rajan’s concerns, and academics intensified their attempts to understand whether the apparent costs of financialization were offset by benefits, including fostering innovation.Robin Greenwood and David Scharfstein tackled this issue by looking closely at which parts of the financial system accounted for the growth.6 They show that the post-1980 expansion is attributable primarily to the credit intermediation and securities subsectors and, more specifically, to the expansion of household credit and asset management. They also note the rise of securitized assets and short-term financing, but question the social value of these developments. Making it easier for households to borrow short-term may only feed bad consumption habits and ultimately destabilize the economy through overleveraging. In their view, active asset management is overpriced, is overrated as a source of information about securities, and woos talented people from other potentially more socially useful careers. They acknowledge, however, a possible link between increasing household participation in the securities markets and small firms’ increased access to capital, as well as the positive role that active asset managers can play in generating information about small firms.Thomas Philippon has painstakingly measured financial intermediation and concludes that the industry is less efficient at delivering services than it used to be.7 Separately, with co-author Ariell Reshef, he argues that while “a larger financial sector is positively correlated with economic growth”, that relationship may not hold in an overmature case like the present-day United States, which has long had a large, highly developed, expanding financial sector.8 A recent International Monetary Fund working paper concluded similarly, “There is a threshold (which we estimate to be [credit to the private sector] at around 80–100% of GDP) above which finance starts having a negative effect on economic growth.”9 The U.S. economy is well beyond this threshold.What does all this mean for innovation? A recent study that looked at a half century of financial development in the United States found a clear, positive link between the financial system and meaningful innovation.10 For public companies in industries dependent on external financing, financial development led to a higher frequency of entry and exit of firms into and out of the marketplace (think Schumpeterian creative destruction). The study also found a rise in research and development spending, patents, and intangible firm assets (which may be another indicator of innovation).By contrast, the Kauffman Foundation—pointing to the drop in the rate of start-ups, “the drop in entrepreneurial intention”, and a drop in the quality of firms resulting from increased access to funds—argues strongly that financialization has been detrimental to entrepreneurship. It imagines that in “an era with a smaller financial sector, we might experience a happy concordance between a financial sector focused on ‘real’ wealth creation and a steady supply of companies seeking financial services”, and predicts that the entrepreneurship rate would rise by roughly 2 to 3 percent if the financial sector shrunk back to its 1980 size.11 The argument here, essentially, is that the lucrative lure of the financial services industry actually drains resources from riskier entrepreneurial efforts.As we know all too well, financial crises hurt the broader economy and divert resources from productive uses—such as R&D—toward crisis response and recovery. So if an overly financialized economy is more accident-prone, its ability to serve innovators is impaired. While some blame the crisis entirely on the financial sector, government housing, regulatory, and monetary policies were also at least partly to blame. The financial industry responded to government incentives to pour money into the housing sector (resources that did not go toward innovation), and Federal Reserve policies appear to have facilitated the investment boom. Financial regulations, such as capital rules favoring highly rated residential mortgage-backed securities, also skewed incentives. Thus, both the boom and the bust prevented resources that would otherwise have been channeled into productive innovation from getting there, but it is not clear that financialization itself, as an independent variable, is to blame.As even financialization’s detractors acknowledge, small firms can be its beneficiaries. Big firms, about which there is a lot of easily available information, have more access to funding than smaller firms. Banks are more likely to lend to large firms. Investors have more information upon which to base an investment decision. Markets in securities of large firms tend to be liquid, because there is a big pool of willing buyers and sellers. A larger financial sector, with more lenders, investors, and traders, makes it easier for small firms to find capital.While innovation can occur in firms of all sizes, many important innovations come from small firms challenging entrenched ones, but only if they have the capital to do so. According to Randall Morck and Bernard Yeung, large firms are more likely to be responsible for “incremental innovations” while small firms are more likely to gin up “more radical innovations.”12 The National Science Foundation’s 2012 report, Science and Engineering Indicators, found that companies with fewer than five employees were important sources of innovation in industries such as biotechnology, the internet, and computer software. Innovations in these industries do not require the massive initial expenditures that only a larger company can make.Understanding where and how innovation occurs is an important part of identifying the link between financialization and innovation. Innovation, however, is a mysterious and messy process. The late Gerhard Rosegger, a Case Western Reserve University economist, found that there is no neat theoretical framework for explaining it, let alone fostering it: “The only thing we do know is that the search for new technical ideas is replete with redundancies as well as blind alleys and therefore, by its very nature, violates the rules of productive efficiency.”13Measures of innovation are themselves imperfect. One can measure inputs, such as spending on R&D, but innovation outputs might not be proportionate (although some correlation between R&D spending and patents exists). An alternative measure is patents applied for or granted. A patent, however, may not result in an innovation, and an applicant may not even intend to create a product based on it. The patent problem can be addressed by narrowing consideration to fruitful patents, meaning those that are frequently cited. But the patenting rate is also affected by other factors such as patent law developments and bureaucratic efficiency.Another complicating factor is that a large share of patents go to non-U.S. inventors. According to the Science and Engineering Indicators 2012 report, the percentage of U.S. patents granted to U.S.-based inventors fell from 54 percent in the late 1990s to 49 percent in 2010. (Of course, some of these may be financed by the U.S. financial sector, which, according to the Commerce Department, exported $92.5 billion in financial services in 2011.) Choosing among imperfect measures, the following chart shows private R&D investments since 1960. There has been an increase in private R&D spending, albeit not a steady one, to about 2 percent of private GDP.A well-functioning financial system is not the only, or even the most important, ingredient for innovation. Innovation levels may ebb and flow over time regardless of objective metrics. Tyler Cowen argues in The Great Stagnation that we are in an innovation slump because we have picked all of the low-hanging fruit. As he puts it, “apart from the seemingly magical internet, life in broad material terms isn’t so different from what it was in 1953.” He remains “optimistic about getting some future low-hanging fruit”, but suggests that we may have a long wait.Even if we cannot guarantee ourselves a constant supply of world-changing innovations, and even if—once we have them—we have to wait for people and organizations to put them to use, we can create an environment in which innovation is more likely. Cowen, for example, suggests improving education and increasing the status of scientists. Some factors, such as a strong intellectual property regime, are obvious (although, as it turns out, how strong it should be is not so obvious). A Canadian study identified numerous positive and negative factors in innovation, including intellectual property rights and the geographical location of firms in relation to one another. It even suggested more broadly that foreign “governments interested in fostering innovation should subsidize American culture, rather than decry and impede it.”14 Indeed, the United States with its diversity, flexibility, and rebellious past may be particularly congenial to innovators. Rosegger argued persuasively that the best environment for innovation is a bit messy:
This heterogeneity is rooted as much in the mix of small, medium, and large firms as it is in the absence of any monolithic “visions” and “concepts” for the propagation of technological advances. . . . I am persuaded of the superiority of our self-organizing system—in other words, of an apparent chaos that would offend every central planner’s and policymaker’s sensibilities.15
If innovation defies neat theorizing and careful orchestration by central planners, it likely thrives when served by a heterogeneous and flexible financial system. As the American financial system has grown, its flexibility and diversity also have increased.Innovators are by nature persistent and creative, and what is more, they learn. Throughout history, they have adapted themselves to the financial system by finding direct or indirect access or by working through informal funding channels. A fascinating volume edited by Naomi Lamoreaux and Kenneth Sokoloff, Financing Innovation in the United States, 1870 to the Present (MIT Press, 2007), illustrates this phenomenon and the corresponding ability of those with money to change the course, location, and pace of innovation. Investors in both Cleveland and Detroit, for example, played a big role in financing the local innovation that put those cities on the map. As Lamoreaux and Sokoloff observed, “Perhaps the most striking aspect of the record of innovation over American economic history is the flexibility that technologically creative entrepreneurs have exhibited in adjusting their business and career plans so as to obtain financing for, and extract the returns from, their projects.”Few micro-innovators can get a bank loan, let alone conduct a public offering. For many innovators, the most viable source of funding is family and friends. I might lend my brother money to help bring his great idea to market based primarily on my sisterly conviction that all of his ideas are brilliant, and I might also charge him a well-below-market interest rate. But not every innovator has such a great relationship with a generous and optimistic sister with money to lend. These innovators may instead rely on personal credit cards or a home equity line of credit. Companies also rely on trade credit from suppliers. Many innovators endure difficult, lean years in the hopes that their company will be noticed and acquired by larger firms. Big companies have established relationships with banks, access to public capital markets, and money coming in from existing lines of business.The financial system can change the leverage an innovator has in negotiations with a potential acquirer. The more sources of funding available to an entrepreneur, the greater her ability to demand more for her innovation from a large company that wants to buy it, and the greater her incentive to take the risks necessary to innovate in the first place. A well-developed financial system provides more of these options. Raghuram Rajan and Luigi Zingales find that financial development matters more for newcomers than it does for incumbent firms.16Rajan and Zingales also demonstrate that certain industries tend to rely more on external financing for growth than others, which means innovation in these industries is also more sensitive to changes in the financial system. For firms in these industries, how well public financing markets function matters a lot. In a recent paper, New York University professors Viral Acharya and Zhaoxia Xu show that large publicly traded firms for which external financing is important are more innovative (based on patent quality) than their private counterparts.17Third-party, arm’s-length financing can be an effective way for an innovative firm to test the value of its ideas. When I lend money to my brother, I ask far fewer questions than a bank would about his plan for commercializing his innovation. And a company that undertakes an initial private offering has to convince both the company’s investment bankers and prospective investors of the worthiness of its plans. A company that looks to a knowledgeable venture capital fund or angel investor for funding may face even tougher questions.Market tests are not easily replicated by government when it steps in to provide funding. Government may invest on the basis of policy fads (such as the recent “clean energy” push) or a firm’s connections with politicians or regulators (which take an innovator’s time and effort to cultivate). Federal and state governments play a very large role in R&D funding. According to NSF data, Federal agency R&D spending was $133 billion in 2009. State government R&D expenditures were $1.4 billion in 2011. The government’s role as a major source of funding makes it more difficult to understand the relationship between the private financial system and innovation.Direct government financing is not the only way government influences the direction and amount of innovation. The government also channels private financing by directing it toward favored industries or technologies; tax credits are sometimes used to achieve this. Unfortunately, sometimes government policy preferences direct money away from innovation, and often it does so though the influence of politically powerful interest groups. Absent government incentives to build, buy, and finance houses before the crisis, some private sector money that went into housing likely would have gone into more innovation-intensive industries. By subsidizing investments in housing, the government raised financing costs for innovators (other than those who drew on their home equity to fund their innovations).Sometimes government policy preferences direct private money toward a favored type of innovation, such as ethanol or solar energy. It is not surprising to see oil moguls embracing green energy. Subsidies need not be direct monetary subsidies, but can come through regulation. The Patent and Trade Office ran a pilot program in which “green technology” patents got expedited review. Under the banking laws, certain wind energy projects can be counted as “public welfare investments”, which enjoy regulatory privileges and may generate tax credits for the investing bank. Subsidy-chasing investments likely divert funds from other industries and technologies where meaningful innovation is more likely to occur. People concerned about innovation should be more worried about this quasi-governmental industrial policy than about financialization.In addition, financial regulation that seemingly has nothing to do with innovation can nevertheless affect it. For example, a recent study found that lifting interstate and intrastate banking restrictions during the 1980s and 1990s stimulated innovation at firms dependent on bank financing.18 Another study found that small firms’ patent activity rose thanks to interstate banking deregulation but was harmed by intrastate banking deregulation, which may have served to strengthen the competitive position of local banks.19 Implicit or explicit government guarantees of large financial institutions, or regulatory burdens that fall disproportionately on small financial institutions, can in turn impair small banks’ survival. Small companies may find it difficult to obtain loans to fund innovative activity, since small banks are an important source of loans for small companies. Banks may also be dissuaded from lending to small businesses for fear that a bank examiner will second-guess the lending decision. Because many small businesses rely on consumer financial products, such as proprietors’ personal credit cards, initiatives by the new Consumer Financial Protection Bureau could negatively affect innovation.Innovations in the financial sector over time have clearly benefitted innovators in the rest of the economy. Venture capital funds play a very important role in innovation in the United States, and the vast majority of venture capital funds are American. These funds set out to identify and fund innovative firms in sectors such as pharmaceuticals and medical devices. They can commit capital for a long enough time to see those innovations pay off and may have specialized expertise in them. Angel investors—individual investors who make large investments in early-stage companies—also play an important role in financing small innovators. According to NSF data, venture capital funding stood at $34 billion in 2010, and angel investment has ranged from $1 billion to $10 billion per year during the past decade. The NSF also reported, however, that venture capital funds are increasingly backing later-stage companies, which suggests that less seasoned innovators may have to look elsewhere for funding.Other recent regulatory changes may actually help to open up new funding channels for small companies. The recently passed JOBS Act allows crowdfunding and loosens other restrictions on raising capital that might help small innovative businesses. Crowdfunding would allow entrepreneurs, subject to certain constraints, to solicit money from small investors. In December 2013, the Securities and Exchange Commission proposed rules under another provision of the JOBS Act that would enable small companies to raise up to $50 million a year. These changes could reshape the financial sector so that it better serves innovators.In addition to worrying that the financial system is not supporting innovation, some are concerned that it may be actively harming it by diverting technology and human resources that could instead have gone into innovative industries. Philippon and Reshef have shown that the U.S. financial sector is not particularly technologically advanced, so its diversion of technology may not be a big concern.20 But the Kauffman Foundation worries that bright minds are being diverted:
Most of the industry’s profits come from the creation, sales, and trading of complex products [that] require significant financial engineering, often entailing the recruitment of master’s- and doctoral-level new graduates of science, engineering, math, and physics programs. Their talents have made them well-suited to the design of these complex instruments, in return for which they often make starting salaries five times or more what their salaries would have been had they stayed in their own fields, and pursued employment with more tangible societal benefits.21
There is a follow-on effect, namely that the sectoral brain drain means there are fewer good investment opportunities for the finance sector, which results in further misallocation of resources. Employment in the financial sector has risen, but not dramatically. The Kauffman Foundation concludes that “[i]t seems certain that financialization, an effect and cause of entrepreneurial capitalism, subsequently cannibalized entrepreneurship in the U.S. economy.”22 On the other hand, a well-functioning financial system makes it more lucrative for would-be entrepreneurs to pursue their dreams, because their prospects of cashing in are better and they have a greater ability to pass off some of the risk of their innovative venture.Even if the growth of our financial markets does not seem to be matched by corresponding advances in innovation, increasing diversity and flexibility in the U.S. financial sector gives innovators more options, which likely contributes to future innovation. We have seen that the financial system plays a role in how, whether, and where innovation proceeds. Even very subtle regulatory changes in the financial sector can have major effects on innovation. Therefore, we must take great care before dismantling pieces of the financial sector in order to shrink it to its seemingly proper size. Doing so may pull the rug out from innovators in the real economy.The plain fact is that we don’t yet know enough about the relationship between the size and nature of the financial sector to start passing laws reining it in. Factoring in the global context in which both innovation and finance operate makes the analysis even more difficult. On the one hand, curtailing financialization domestically could defund innovation abroad in countries desperately in need of economic growth. On the other, adopting laws and regulations that encourage pieces of our financial sector to go elsewhere could make it harder for domestic innovators to access funds. 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.
1Baily and Elliott, “The Role of Finance in the Economy: Implications for Structural Reform of the Financial Sector”, Brookings Institution, July 11, 2013.2Cochrane, “Finance: Function Matters, Not Size”, Journal of Economic Perspectives (Spring 2013).3Dennis K. Berman, “A Riddle: Is a Peanut Butter Pop-Tart an ‘Innovation’?”, Wall Street Journal, December 4, 2013.4National Science Board, Science and Engineering Indicators 2012 (National Science Foundation, 2012).5Rajan, “Has Financial Development Made the World Riskier?” Jackson Hole Symposium (August 2005).6Greenwood and Scharfstein, “The Growth of Finance”, Journal of Economic Perspectives (Spring 2013).7Philippon, “Has the U.S. Financial Industry Become Less Efficient: On the Theory and Measurement of Financial Intermediation”, NBER working paper (October 2013).8Philippon and Reshef, “An International Look at the Growth of Modern Finance”, Journal of Economic Perspectives (Spring 2013).9Jean-Louis Arcand, Enrico Berkes, and Ugo Panizza, “Too Much Finance?” IMF working paper (June 2012).10Claire Y.C. Liang et al., “U.S. Financial Markets Growth and the Real Economy”, paper delivered at International Conference of the French Finance Association (AFFI) 2011 (May 2013).11Paul Kedrosky and Dane Stangler, “Financialization and Its Entrepreneurial Consequences”, Kauffman Foundation Research Series (March 2011), pp. 13–14.12Morck and Yeung, “The Economic Determinants of Innovation”, Industry Canada Occasional Paper No. 25 (January 2001), p. 25.13Rosegger, “How Can We Improve the Context for Innovation?”, Canada-United States Law Journal, Vol. 21 (1995), p. 334.14Morck and Yeung, “The Economic Determinants of Innovation.”15Rosegger, “How Can We Improve the Context for Innovation?”16Rajan and Zingales, “Financial Dependence and Growth”, American Economic Review (June 1998).17Acharya and Xu, “Financial Dependence and Innovation: The Case of Public versus Private Firms”, National Bureau of Economic Research Working Paper No. 19708 (December 2013).18Mario Daniele Amore et al., “Credit Supply and Corporate Innovation”, Journal of Financial Economics (September 2013).19Sudheer Chava et al., “Banking Deregulation and Innovation”, Journal of Financial Economics (September 2013).20Philippon and Reshef, “An International Look at the Growth of Modern Finance.”21Kedrosky and Stangler, “Financialization and Its Entrepreneurial Consequences”, p. 6.22Kedrosky and Stangler, “Financialization and Its Entrepreneurial Consequences”, p. 11.