March 25, 2011 – The expansion of the financial sector over the past few decades shifted the flow of capital toward financial assets, creating inefficiencies that had material economic impacts, according to "Financialization and Its Entrepreneurial Consequences," a study the Ewing Marion Kauffman Foundation released today.
One of those impacts may have been the financial industry's effect on entrepreneurship. Although widespread entrepreneurial capitalism requires a significant and active financial services sector, the industry's growing size potentially suppressed entrepreneurship as financial services and young companies compete for many of the same employees, according to the study.
The financial sector, which includes lending, stock brokerage, complex securities and insurance, among many other services, derives enormous profits from collateralized debt obligations. These new products require such sophisticated engineering that the industry now focuses its recruiting on new master's- and doctoral-level graduates of science, engineering, math and physics, and pays them starting wages that are five times or more what they would have earned had they remained in their own fields.
"Because these new hires are often the very individuals who otherwise would have comprised the most robust pool of prospective founders of high-growth companies, the financial services industry's steady rise has had a cannibalizing effect on entrepreneurship in the U.S. economy," said Paul Kedrosky, Kauffman Foundation senior fellow and one of the paper's authors. "Excessive financialization exacerbated and distorted the flow of capital in the economy, potentially suppressing entrepreneurship by drawing away entrepreneurial talent."
History has shown that human and other capital inevitably flows to the opportunities that provide the highest risk-adjusted returns. Regulations and feed processes can change these capital allocations, however, tilting the balance by starving some sectors and opportunities, while creating a flood of capital for others, leading to inflated or deflated asset prices, reduced productivity, less innovation and less entrepreneurship, thus lowering job creation and overall economic growth.
"While the rate of entrepreneurship fell and then flattened over the past two decades, financialization also likely affected the caliber of startups," said Dane Stangler, Kauffman research manager and co-author of the paper. "An excessively dominant financial sector may have made it easier for weaker (or potentially weaker) companies to obtain financing, thus helping to maintain that steady rate of entrepreneurship but possibly contributing to the declining quality of newly established businesses."
When the financial sector shrinks as a share of GDP, as it is likely to do in the near future, the study predicts it will coincide with a number of other trends and help increase the rate of new business creation, as well as providing an environment for higher social value from new companies. The authors note that while a "smaller" financial services sector will be smaller relative to recent history, it still likely will be larger than in prior decades, meaning that it could continue to provide the financial intermediation services young companies need most.
A smaller financial sector also should improve allocative efficiency among technical graduates, and among financial services employees who lose their jobs in the industry but respond by establishing companies that otherwise might not have existed.
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