Anatomy of the Global Economy
America’s Financial Leviathan
J. Bradford DeLong
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BERKELEY – In 1950, finance and insurance in the United States accounted for 2.8% of GDP, according to US Department of Commerce estimates. By 1960, that share had grown to 3.8% of GDP, and reached 6% of GDP in 1990. Today, it is 8.4% of GDP, and it is not shrinking. The Wall Street Journal’s Justin Lahart reports that the 2010 share was higher than the previous peak share in 2006.
Lahart goes on to say that growth in the finance-and-insurance share of the economy has “not, by and large, been a bad thing....Deploying capital to the places where it can be best used helps the economy grow...”
But if the US were getting good value from the extra 5.6% of GDP that it is now spending on finance and insurance – the extra $750 billion diverted annually from paying people who make directly useful goods and provide directly useful services – it would be obvious in the statistics. At a typical 5% annual real interest rate for risky cash flows, diverting that large a share of resources away from goods and services directly useful this year is a good bargain only if it boosts overall annual economic growth by 0.3% – or 6% per 25-year generation.
There have been many shocks to the US economy over the past couple of generations, and many factors have added to or subtracted from economic growth. But it is not obvious that the US economy today would be 6% less productive if it had had the finance-insurance system of 1950 rather than the one that prevailed during the past 20 years.
There are five ways that an economy gains from a well-functioning finance-insurance system. First, people are no longer as vulnerable to the effects of fires, floods, medical disasters, unemployment, business collapses, sectoral shifts, and so forth, because a well-working finance-insurance system diversifies and thus dissipates some risks, and deals with others by matching those who fear risk with those who can comfortably bear it. While it might be true that America’s current finance-insurance system better distributes risk in some sense, it is hard to see how that could be the case, given the experience of investors in equities and housing over the past two decades.
Second, well-functioning financial systems match large, illiquid investment projects with the relatively small pools of money contributed by individual savers who value liquidity highly. There has been one important innovation over the past two generations: businesses can now issue high-yield bonds. But, given the costs of the bankruptcy process, it has never been clear why a business would rather issue high-yield bonds (besides gaming the tax system), or why investors would rather buy them than take an equity stake.
Third, improved opportunities to borrow allow one to spend more now, when one is poor, and save more later, when one is rich. Households are certainly much more able to borrow, thanks to home-equity loans, credit-card balances, and payday loans. But what are they really buying? Many are not buying the ability to spend when they are poor and save when they are rich, but instead appear to be buying postponement of the “unpleasant financial retrenchment” talk with the other members of their household. And that is not something you want to buy.
Fourth, we have seen major improvements in the ease of transactions. But, while electronic transactions have made a great deal of financial life much easier, this should have been accompanied by a decrease, not an increase, in the finance share of GDP, just as automated switching in telecommunications led to a decrease in the number of telephone switchboard operators per phone call. Indeed, the operations of those parts of the financial system most closely related to technological improvements have slimmed down markedly: consider what has happened to the checking operations of the regional Federal Reserve Banks.
Finally, better finance should mean better corporate governance. Since shareholder democracy does not provide effective control over entrenched, runaway, self-indulgent management, finance has a potentially powerful role to play in ensuring that corporate managers work in the interest of shareholders. And a substantial change has indeed occurred over the past two generations: CEOs focus much more attention than they used to on pleasing the stock market, and this is likely to be a good thing.
Overall, however, it remains disturbing that we do not see the obvious large benefits, at either the micro or macro level, in the US economy’s efficiency that would justify spending an extra 5.6% of GDP every year on finance and insurance. Lahart cites the conclusion of New York University’s Thomas Philippon that today’s US financial sector is outsized by two percentage points of GDP. And it is very possible that Philippon’s estimate of the size of the US financial sector’s hypertrophy is too small.
Why has the devotion of a great deal of skill and enterprise to finance and insurance sector not paid obvious economic dividends? There are two sustainable ways to make money in finance: find people with risks that need to be carried and match them with people with unused risk-bearing capacity, or find people with such risks and match them with people who are clueless but who have money. Are we sure that most of the growth in finance stems from a rising share of financial professionals who undertake the former rather than the latter?
J. Bradford DeLong, a former assistant secretary of the US Treasury, is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau for Economic Research.
Copyright: Project Syndicate, 2011.
www.project-syndicate.org
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MarkPitts 12:54 31 Dec 11
The author demonstrates surprisingly weak economic reasoning. Just to take a few of his points:
1) There is no reason to believe that money spent on financial services is “diverted” from other uses. As most of us learned in our first econ course, it is not a zero-sum game.
2) The financial services sector has never sought to guarantee the value of housing or the stock market. Thus, variation in the value of these investments hardly constitutes a failure of the financial industry to distribute risks. On the other hand, instruments for distributing financial risks, for those who care to use them, are vastly more complete now than in the past.
3) Junk bonds, like all bonds, occupy a different position on the capital structure than equity. There is no reason that different investors with different risk preferences should all prefer equity investments. When corporations tailor capital to investor preferences, for example by offering debt as well as equity investments, all parties come out ahead. Additionally, it allows startup corporations to avoid total dependence on bank lending.
4) The author misses the point that financial services since the 1950s are in fact very much like telecommunications. In the 50’s, for example, commissions and long distance phone calls were both quite expensive. Now long distance phone calls are cheap, but we spend more than ever on telecommunications, primarily because they offer us so much more than in the past. Similarly, we spend more than ever on financial services, despite the fact that commissions and other transaction costs are now very low. This is sign of success, not failure.
The author essentially takes a central planning approach to economics; that is, wanting to dictate from above the amount that should be spent on various sectors of the economy rather than letting economic agents determine the right allocation by their own economic decisions.
The author’s failure to see the benefits of American supremacy in financial services seems to flow from some source other than economic reasoning.
Dr. Mark Pitts
The Aid and Education Project, Inc.
erhoades 01:18 31 Dec 11
In order to have an accurate understanding of how much the financial/insurance sector has grown one would have to strip out how much of it is due to globalization, how many of these services are exported as compared to years past.
It is also possible that part of this dynamic could be partially due to the shrinking of other parts of the economy, rather than the growth of this sector. If real spending on finance/insurance were to remain constant, and manufacturing were to drop then finance/insurance would have a larger percentage of GDP by default.
All in all I am sure that with the proliferation of financial instruments that this sector has grown, it would just be nice to have the numbers presented in a more realistic fashion.
Charlesst 09:15 31 Dec 11
This comes to your attention now! See:
http://anamecon.blogspot.com/2010/06/that-bloated-financial-sector.html
The financial sector is simply too big to have a net benefit on the economy. In order to make a profit, it must maintain itself through government subsidy, blackmail, and deceitful and illegal practices. The rest of the economy, that which actually produces things, must work 5% harder just to maintain its bloated, self-serving condition.
myerscpa 11:24 31 Dec 11
David Kennedy wrote a great history of the New Deal era "Freedom from Fear" in 1990's. Overall, I thought the big takeaway was that the New Deal was about risk reduction. You could trust the banks after deposit insurance, investment banking was separated from commerical banking, old age poverty was alleviated by Social Security, the power of federally guaranteed home mortgages was established, international security through alliances, and the list goes on and on.
The reduction of risk allowed the American economy after World War II to be enormously productive, partially because for the first time in its history the American banking system was under the supervision of the people, and not the plutocracy.
Starting in 1980s, the Republican party's initiatives in almost all areas has been to introduce risk back into the American economy and American life. This apparently is more of a byproduct of the Republicans' desire to concentrate wealth, but nevertheless it is a very pernicious outcome. And much of this reintroduction of risk has subtracted from growth, not heightened it. Why? Because it is financial system risk that has been increased, which makes the goods and service producing sector more risky without a commensurate benefit.
What to do? One approach would be through regulation to move more of America's banking business out to regional and community banks and away from big money center banks. That would get the benefits of finance out into the country where it might do some good. And the more you disperse risk, the more overall risk you can take on. Today, there's lots of risk in New York and lots of caution in the rest of the country. That is precisely backwards from what good economic growth would require.
And yes, if you can't make finance better, by all means make it smaller. But that will be hard to do because Washington is mostly an Imperial Capital and aggrandizement is its natural proclivity.
Paul A. Myers
0spinboson 01:27 02 Jan 12
Rentier capitalism is great. (Why is this news?) You really owe David Harvey an apology for your substanceless ad hominem from a few years ago. For the rest, look up the work of Bill Black. The Best Way To Loot a Bank is to Own One indeed.
LEEDAP 11:55 03 Jan 12
Dr Mark Pitts, thou dost protest too much. As you said yourself, DeLong takes a central planning approach where as yours appears narrowly focused. Mr Myers understands the structural problems we are facing. The finance industry gets rich by taking a cut from the shifting tides of risk first fuelled by a housing bubble created by loose lending, then when shifting it to unsuspecting investors, and finally from the federal dollars pumped in to save us from the collapse. The elephant in the room here is that we all know which industry is to blame for the recession.
The finance industry drives up prices with its ever increasing array of financing wizardry and then taxpayers rescue the insurance industry when the market collapses. We're seeing this happening again with student loans, the price of tuition and the rates of default. Even our health system obfuscates any reasonable price control while putting thousands into bankruptcy from an insurance industry unable to provide adequate coverage.
The fact that Volker failed to imbue reason into the industry after the financial collapse is evidence of the intractable power the industry has over government. The risk taking is legal corruption and it’s going to slow future growth the same way any 3rd world corruption does- insidiously.
ohneeigenschaften 01:37 08 Jan 12
Of course another contribution of US finance and insurance is to the current account: many important services of US finance are exported to foreigners, and thus help to balance out the trade (in goods) deficit. One should check the numbers to see how the US surplus in financial services has evolved over this period. Looking at it as a wholly domestic industry is thus misleading. Whether this contribution is large enough to justify the growth of the industry is still an open question.
No one would doubt that the large financial services industries of Switzerland or the Cayman Islands make a contribution to their welfare as nations (if a dubious contribution to the world's welfare). Britain, e.g., had a positive current account throughout the 19th c despite a trade deficit much of the time precisely because of its surplus in financial, insurance and shipping services.
JakeLopata 11:05 30 Dec 11
The column reminds me of Adam Smith, Book II: Of the Nature, Accumulation, and Employment of Stock (Wealth of Nations).
I have a better understanding of 'money' and its fundamental purpose after studying Book II.
The financier does not care to recognize the difference between the "...two sustainable ways to make money..." due to the reason noted previously, shareholder interests.
What are those interests? Return on investment (ROI), why else would they lend the money in the first place if not for a profit?
It would not be surprising to learn the industry is, in fact, over-sized.