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Thought Leadership

Why is financial services at the heart of the economy?

The make-or-break layer that keeps the others running.

Date:
May 2, 2022
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To see how the Economy Stack model works, we can start by understanding how sectors are influenced by (or not influenced by) international trade.

Trade-ability 

We want to understand how these sectors are influenced by international trade.

Not all sectors are tradeable: the proverbial example is “the hairdresser”. The service can only be dispensed locally and must stay within the boundaries of an economy. No one in France will pay for hairdresser services delivered within the UK.

All in all - 18 of these sectors have the potential to be highly tradable. They can be exported outside the boundaries of a country, even if produced within the country. 

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This is why trade has such a big influence on economic growth. Many sectors have the potential of international trade. On average, the value of combined import-export trade is 40-60% of the gross-revenue of GDP. This varies depending on how open an economy is, and how competitive it is as an exporter.

A country just needs to have an export competitiveness - termed a ‘comparative advantage’ by economist David Ricardo - in just 2-4 key sectors in order to have a successful export-driven economy.

For example, South Korea has a comparative advantage in Shipping, Semiconductors (within manufacturing) and Automotive. Germany is strong at Manufacturing and Automotive. The UK is strong at Financial Services and Education. India has an export strength in Pharmacology and Technology.

Input-Output Models

Not all sectors produce ‘final goods’. This refers to goods that are consumed directly by consumers.

If a good is not a ‘final good’ (or not always so) then it is consumed by another sector in order for that sector to produce its own goods and services.

For example, energy is consumed directly by consumers like you and me, so it is a final good. But it is also consumed by factories or hospitals or schools, for them to do their work and make their goods and services. So it is an input to the sectors.

You can analyze the relationships between sectors with an input-output framework, inspired by the work of Wassily Leontief. This shows how some sectors feed into others, as inputs.

Below is an example framework - with just a selection of sectors.

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We can highlight cells where there is a strong input to output relationship. In a fully fledged model we can even quantify the exact flows in terms of priced goods - economy activity - that move between sectors every year.

In 2009, I was working for a large upstream oil company based in the U.K. They owned a large number of offshore oil reserves in the deep sea waters of Brazil. By 2010 Brazil was on course to have a power transition at the Presidential level: same political party but a new political leader. The company I was working for needed a valuation of these oil assets - currently worth in the billions of dollars.

The incoming Brazilian government was likely to inject spending into particular sectors. Working with the McKinsey Global Institute, I needed to assemble the macroeconomic data and build an input-output model to precisely quantify how a lift in activity in select sectors was going to trigger a boom in the oil sector of the economy, and so increase the valuation of the offshore oil reserves.

An input-output model is helpful to understand how a sudden growth in one sector - e.g., due to an export boom in technology - will support economic activity throughout the domestic economy, because all other sectors need to produce inputs to fuel this export-driven sector, that is suddenly doing well. In economics, this is called the multiplier effect. An increase in one area of the economy causes a multiplier of economic activity throughout the rest of the economy.

Once you quantify the flows in individual cells, you have the ability to see how a spike in one particular cell will cause a vibrant chain-reaction through other cells, from the input-output, and lift the economic activity across many other sectors.

Two sectors in particular have the ability to cause seismic chain reactions - positive and negative - if they are triggered.

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Financial Services and Energy at the heart

When you analyze an economy this way, it enables us to see which sectors are most strongly linked with others. Typically there are two that stand out above all others: Energy and Financial services. You can see this in the framework above: the number of green cells they have for each of their rows.

Why is this?

All sectors must consume a good or service from Energy or Financial services in order to make their own products or services. Energy is a fundamental need for any production, and the movement of funds and financial products to support a business, is a fundamental need for any business in any sector.

This is why economies are so sensitive to an increase in energy costs. Such spikes can cause an economic downturn, notably in the 1970s. In 1973, there was an OPEC triggered oil price increase; and in 1979 there was a Middle Eastern war (Yom Kippur) and a revolution in Iran. These sudden events reverberated through Western economies and caused economic slowdowns, and even influencing political power transitions by the early 1980s: Ronald Reagan and Margaret Thatcher.

As importantly, economies are highly sensitive to a crash in the financial sector. There is a big risk of ‘contagion’: something going wrong in the financial sector leading to a crash in the wider economy. Without the flow of money - especially the flow of credit - businesses and governments can suddenly lose the ability to function. A recent example is the 2008-2010 economic recession caused by the subprime mortgage crisis, which was a specific sub-sector within financial services. A crash in the financial sector had the effect of causing contagion throughout the economy. It reduces the economic activity across most other sectors, leading to the global economic recession we faced in 2008-2011.

Both energy and financial services are the lifeblood of an economy. The input-output framework shows you why this is. They serve as inputs to all other sectors of an economy. If something goes wrong for one of them, all other sectors are affected and the whole economy can be brought down. Right now, in the Russia-Ukraine crisis, we are seeing how important it is that Western European economies have secure supplies of energy. We are seeing just how sensitive they are to the risk of losing access to oil and gas, from Russia.

 

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Article by
Avi Patchava
CEO (joint), Bright Money

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