Why Is Finance So Big?

By James Kwak

This is a chart from “The Quiet Coup,” an article that we wrote for The Atlantic three years ago next month. Many people have noted that the financial sector has been getting bigger over the past thirty years, whether you look at its share of GDP or of profits.

The common defense of the financial sector is that this is a good thing: if finance is becoming a larger part of the economy, that’s because the rest of the economy is demanding financial services, and hence growth in finance helps overall economic growth. But is that true?

Thomas Philippon is trying to figure this out. In an earlier paper, he looked at demand for financial services from the corporate sector and concluded that growth in the financial sector from 2001 could not be attributed to increasing demand. In a recent working paper, “Has the U.S. Finance Industry Become Less Efficient?“* he now measures the finance share of GDP against the total production of financial intermediation services by the sector. For the latter, he uses time series of corporate debt, corporate equity, household borrowing, deposits, and government debt. The conclusion is that the per-unit cost of financial intermediation has been going up for the past few decades: that is, the financial sector is becoming less efficient rather than more, and that accounts for two percentage points of finance’s share of the economy.

Theoretically, finance could be providing other benefits that aren’t captured in the output series, such as improved pricing or better risk management. Philippon does provide some evidence to be skeptical of those claims.

The main reason why finance’s share of GDP has outstripped its production of intermediation services, according to Philippon, is a huge increase in trading volumes in recent years. Trading, of course, generates fees for financial institutions, with limited marginal social benefits. Yes, we need some trading to have price discovery. But if I sell you a share of Apple on top of the other 33 million shares that were traded today, is that really helping determine what the price of Apple should be? The more that financial institutions can convince us to trade securities, the larger their share of the economy, whether or not that activity improves financial intermediation.

There are still a lot of open issues, but Philippon’s approach—measuring what the industry actually does—seems to be a useful one.

* The paper first debuted in the blogosphere back in December. Sorry, I’m behind.

22 responses to “Why Is Finance So Big?

  1. So paying people increasingly outsized salaries for producing precisely nothing — as in finance, management consulting, or law — does nothing to increase the wealth of the society?

    Gee, who could have guessed?

  2. Yep, in real life, certain groups can manage to extract rent. The 30-second supply and demand theory doesn’t explain everything in the world. See this post from National Review:

    This paper from 2009 sticks with me. It makes the plausible argument that investment banking was basically easy, and boring, in the heavily regulated period between 1930 and 1980; that subsequent deregulation and the rise of exotic financial products created great demand for high-skilled workers, thus increasing both wages and the opportunity for profit in the financial sector; but that, nevertheless, financial workers are overpaid. In part by comparing the compensation of financial workers and engineers with similar innate abilities and education levels, the paper concludes that as much as 30-50 percent of financial compensation is pure rent. That is, the financial sector as a whole could get away with paying workers up to 50 percent less without affecting demand for those jobs.

    Consider also Paul Volker’s comment: “I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth — one shred of evidence.” The biggest innovation in the industry over the past 20 years, Volcker added, was the ATM.

    A Kauffman Foundation study concluded that “the industry’s growing size potentially suppressed entrepreneurship as financial services and young companies compete for many of the same employees”.

  3. Bruce E. Woych

  4. Bruce E. Woych

    Below is the link for the video and transcript of an interview with Rocky Anderson, former mayor of Salt Lake City and 2012 presidential nominee of the recently formed Justice Party, direct from the Real News Network.
    Transcript:

    http://thirdpartypolitics.us/blog/2012/02/17/the-real-news-interview-%E2%80%98why-is-rocky-anderson-running-for-president%E2%80%99/

  5. Bruce E. Woych

    Rocky Anderson :

  6. Bruce E. Woych

    Compare “Finance” to Viral reproduction: especially the Lytic cycle explains how finance has become so big. It cannabalizes existing infrastructure and utilizes its metabolic proicess to reproduce itself …to go and invade other “healthy” cells (commercial / production industries)

    http://en.wikipedia.org/wiki/Lytic_cycle

    ——————————————————-
    Viruses are true parasites that can’t live on their own, but go into host cells to reproduce … of genetic material—either DNA or RNA—carried in a shell called the viral coat, . … Once inside a host cell, viruses take over its machinery to reproduce.”

    http://archives.microbeworld.org/microbes/virus/

    ——————————————————-
    In the lytic cycle, which is considered the main cycle in viral replication, once the viral DNA enters the cell it transcribes itself into the host cell’s messenger RNAs and uses them to direct the ribosomes.
    The host cell’s DNA is destroyed and the virus takes over the cell’s metabolic activities.
    The virus begins using the cell energy for its own propagation. The virus produces progeny phages. These replicate fast, and soon the cell is filled with 100-200 new viruses and liquid. As the cell starts getting overcrowded, the original virus releases enzymes to break the cell wall. The cell wall bursts – this process is called lysing – and the new viruses are released.

    http://www.brighthub.com/science/genetics/articles/30611.aspx

    That pretty much is WHY FINANCE IS SO BIG !

  7. A whole series of post-Keynesian analyses in the tradition of Minsky have pointed out that there has been an increasing in what Minsky called Ponzi finance, which is premised on gambling on increasing asset prices rather than (long-term) investment in real production processes or other business ventures. Phillipon’s “increased trading” is probably the epiphenomenon that is an expression of the underlying phenomenon of attempting to bid up asset prices or gamble on derivatives of asset prices.

    Steve Keen’s analysis is one of a number of post-Keynesian economists who have built models that plausibly explain the boom in finance as asset prices have continued to climb in the past 20 years. http://www.debtdeflation.com/blogs/

    Michael Hudson of U Missouri at Kansas City has a great short description of the evolution of the financial system and the economy, drawing on his 5 decades of experience in the course of this video:

    http://www.nakedcapitalism.com/2012/02/michael-hudson-a-planned-economy-for-the-1.html

  8. In Hell's Kitchen (NYC)

    Finance is big because the evolution of the income distribution from the time of the Great Depression up to the middle ’80s was not to the liking of the 1%-ers of that period. Thus, they decided to use their wealth to capture government (starting with Ronald Reagan) and reverse destroy the system that gave us the post-war period which created the “American Dream.” It was a conscious decision by those 1%-ers to “fix” things so that they can rentier the middle-class to extinction and create the financial gimmicks that allowed them to become 0.001%-ers after the middle ’80s. Two birds with one stone.

  9. Yes, there is more gambling and the finance sector is rife with scoundrels, but…this thread seems to ignore the fact that globalization came as an effort to solve several problems at once, and… the core solution was a trade-off of US manufacturing for a much bigger role for US investors in global investment. It is key to remember that as 4% of the global population, Americans hold more than 50% of global market share, and so, to an extent, the trade-off has been a success. But also, there was the Triffin Dilemma to deal with and the so called ‘demographic dividend’ to take advantage of. Or, the altrustic at heart might see endless cheap labor as needless poverty, but regardless of how it is viewed, the Reagan tax ploys were devised as a way for US investors to gain financial control of the entire world.

    But, from this article, a reader might conclude that US investors have no role in global finance???
    Ray
    to

  10. Blackeyebart

    In 1986, New Zealand took effective measures to control inflation and then let the $Kiwi float without any controls at all. It is now the eleventh most traded currency in the world. It is also the most volatile. Hardly anyone in New Zealand thinks that it is strange to control prices with one hand and let them run riot with the other.

    So any New Zealand importer or exporter has to contemplate purchasing forward cover. Most do. This costs between one or two cents in the dollar.This is not a charge on profits but on turnover. Again almost no-one thinks that this is a lot of money. It is just accepted.

    If the finance markets can gain 1 to 2% of the value of New Zealand imports and exports, without a murmur of complaint, then why wouldn’t they? Four big banks comprise 25% of the NZX.

  11. It’s simply pathetic that anyone who considers themselves anything but mentally handicapped can trick themselves into believing there’s ANYTHING else here except for an industry that’s managed to capture massive rents that contribute to the production of literally nothing of value and reduce welfare for every single person in society not in said industry.

    It’s just obvious if you’ve bothered to actually look at real life data instead of only masturbating over some half-baked PDEs you’re so proud of and that have absolutely nothing to do with anything that’s ever happened in the real world.

  12. My view is that we have had 30 years of wage stagnation, and declining participation in the economy from males. The financial intermediaries have given us bubbles, demonstratable, emprirical, irrefuatable evidence that they can’t make economically viable loans, and can’t assess risk, and are:
    stupid
    corrupt
    stupid and corrupt

  13. ” It is key to remember that as 4% of the global population, Americans hold more than 50% of global market share, …”

    It is key to remember that as 4% of the global population, some Americans hold more than 50% of global market share, …

    And I would suspect the some is about 0.1%

  14. In my experience, the corporate sector is being increasingly funded by its suppliers, not banks. Getting paid by corporations is getting harder and harder. Their procurement demands have steadily increased over the past 8 years. This means to me that corporations are getting too little credit from banks and are effectively borrowing from suppliers – who bear the cost of bidding for work by reverse auction and slow payment. The loser is small business.

    If there is any growing efficiency in the economy, it is not being initiated by the banks. From my POV, though, it is mainly the efficiency of squeezing small vendors out of business.

  15. The reason finance takes a growing share of GDP is that GDP does a bad job of measuring the economy. It only counts what is measured in money. It leaves out the external benefits and costs that are generated in society and the environment. Finance is all money, so all of it is counted.

  16. I think there is considerably less than nothing to the case that trading is good since it leads to more efficient price discovery. Higher trading volume is associated with higher price volatility. Someone (else) in the ivory tower might argue that this is because with low trading asset prices are too smooth — not reacting fully to changes in fundamental value. But really, does anyone seriously believe that ? A 1% or more daily change in stock market indices is quite common. Can anyone argue with a straight face that fundamental value changes that much ? It must be close to a martingale (daily) so that would involve a totally mindbogglingly huge change in expected dividends or required rates of return.

    There is absolutely no doubt in my mind that higher trading volume leads to prices further from fundamental values. I can see how someone might claim this isn’t proven (some people even claim to believe the efficient markets hypothesis) but I can’t convince my self that anyone really believes it isn’t true.

    Finance is hugely profitable for the same reason casinos are hugely profitable — there is a lot of money out there waiting to be taken from a lot of fools.

  17. @In Hell’s Kitchen NYC, “…It was a conscious decision by those 1%-ers to “fix” things so that they can rentier the middle-class to extinction and create the financial gimmicks that allowed them to become 0.001%-ers after the middle ’80s. Two birds with one stone….”

    Still the best at bottom-lining – a New Yorker :-)

    *Finance* went after the basic human right to make your life less miserable through honest work (AKA “The American Dream”).

    So now what are we going to do about it?

  18. Desi Girl - Doing Gods Work

    “…The more that financial institutions can convince us to trade securities, the larger their share of the economy…”

    Ha Ha..Kwak…you do know that you have a job because of the financial services industry?

    First banks convinced you to buy houses, now they force you to trade? is this a country of dumbos? Don’t you ever learn?

    btw, there is a huge problem in this paper by Philippon: on page 10, the Euler equation: Uc(t) is transposed incorrectly. There goes all the time you spent reading another useless academic paper.

  19. OKAY desi- thats a five year wait, I’m talkin about robs gvt capture right now. I’ll drop you like a bad habit when the time comes pal. Now even today’s so called law, can’t out run time!

  20. A Real Black Person

    I thought the size of the finace sector was directly related to longer lifespans in most societies. People who live longer have to set more money aside from retirement. Social security is the bare minimum. Increasingly, an investment portfolio or a performing asset is necessary for most retired people to not live in poverty. This may be partially why we have property bubbles and exotic financial products throughout the world. I don’t know who said it but I remember reading that the global economy’s (not individual economies) problems aren’t too much liquidity but too much saving. Most earnings that would go into stimilating the economy are locked up in safe investments for retirement. It’s almost like we have to trick ourselves into taking care of the old in our individualistic society .

  21. It’s remarkable that the elemental reason, that ***finance adds by %’s***, isn’t mentioned by anyone in this remarkably well versed group.

    It’s adding by %’s that makes an investor’s savings grow exponentially, compared to anyone else’s savings that can only grow linearly. It’s done as we see everyone doing it, by having investing in reliable returns, to be added to your principle.

    Why there are reliable returns available isn’t hard to figure out either, that any business needs to show a profit or be declared “bankrupt” and quickly lose investors. At the limit, though, over-investment in the system can drive the whole business system bankrupt, creating demands for returns only a very few can meet as the economy falls apart.

    That’s all you need to know to see the necessity for investors to divest their returns, in aggregate, to end the escalation of financial demands when the the economy becomes pressed to its limits and unable to deliver.

  22. Which should be in about 3 days from now?