Financialization in the EU and its consequences

Building on ISIGrowth research, in this policy brief we present empirical evidence on the patterns of increasing financialization in the EU in the last two decades, an analysis of its possible adverse effects on several objectives of the EU 2030 agenda, including inclusive growth, innovation, inequality and financial stability. We conclude by providing some policy insights and recommendations. The notion of financialization reflects, on the one hand, the engagement of non-financial firms into financial activities not directly related to production, and, on the other hand, the relative size of the financial sector with respect to the overall economy. Several empirical indicators show that financialization has been increasing in the Euro Area in the last two decades. This finding is important because while financialization has been so far mostly considered to be a driver for growth and innovation, there is today a wealth of theoretical arguments and empirical evidence pointing to the detrimental effects of excessive financialization for growth, innovation, inequality and financial stability. First, excessive financialization depresses economic growth because it implies that a larger fraction of credit is directed 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 buy-backs). 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). We suggest some countermeasures that could help containing excessive financialization, including: (i) fostering the demand in the real sector; (ii) establishing mission-oriented programs by going beyond the traditional conceptual framework to fix market failures and aim to create markets where they may not exist at all; (iii) encouraging the alignment of top managers' compensation schemes with long-term profit and corporate social responsible goals; (iv) studying the possibility of setting a minimal ratio on banks for lending to the real economy (to non-real estate sectors); (v) studying the possibility of setting a maximal level of intra-financial leverage for financial institutions.