Developed nations urged to end bias towards debt-based finance

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The Organisation for Economic Cooperation and Development has called for developed countries to end their bias in favour of debt-based finance which it claims hinders economic growth.

In a report showing that excessive debt was bad for economic growth, the Paris-based international organisation found that the growth of equity finance boosts economic performance in contrast to the harmful effects of bank borrowing.

“Finance is good for growth, but like chocolate, you can have too much of it,” said Catherine L Mann, OECD chief economist.

For many years, the OECD and others have worried about advanced countries’ economic policies artificially favouring debt finance but it now claims to have found a causal link proving the benefits of equity over debt.

The background work studies OECD and G20 countries over a 50 year period, looking for links between the type of finance used both over time and across countries and their respective economic performance.

It found that a lack of credit hurts growth prospects, particularly in poorer and less developed national economies. But in the advanced world large expansions of credit tends to be harmful.

Ms Mann said there was a need to improve incentives to use equity finance in preference to debt, while most countries’ corporate tax systems offer some form of deductibility on debt interest payments. “Tax reforms to reduce this debt bias will help make finance more favourable to long-term growth,” the OECD said.

She added that there was also a need for significantly tighter capital requirements for banks to diminish the subsidies associated with banks still being too important to fail.

The OECD findings are most negative regarding household credit growth. A 10 per cent of national income growth in household debt, it found, was associated with a 0.6 percentage point drop in gross domestic product per person over the longer term.

At the other extreme, a 10 per cent of GDP increase in stock market capitalisation was associated with a 0.2 percentage point increase in national income per head.

The OECD did recognise that any short-term credit squeeze hinders growth. These results, it said, applied in the longer term only, suggesting that banks and much of the finance industry is not effective at directing resources to the most efficient economic sectors.

Fitting in with its core focus on inequalities, the OECD also suggested that the finance industry adds to societal inequality because the sector’s lack of competition allows it to pay more than other industries without generating a correspondingly high economic output.

“Twenty per cent of top income earners work in finance and earn 40 per cent more than similar workers in other industries,” Ms Mann said. “If they are delivering 40 per cent more value to society, you’d say fine, but the evidence is against them.”