Note: This is the first of two related posts.
In his latest New York Times Magazine column, Adam Davidson writes that Wall Street, "play[s] the crucial role of intermediation — matching borrowers with lenders. Most of the time, the industry does this extremely well." Of course, sometimes the industry does it poorly. So how often does Wall Street engage in valueless lending?
To continue the discussion, we asked two economists on different sides of the debate - Thomas Philippon of New York University and John Cochrane of the University of Chicago - to answer the following question:
"How much fat can we cut out of Wall Street?"
Thomas Philippon's response is below. To read John Cochrane's response, click here.
The finance industry represents a larger share of the US economy than ever before. The sum of all profits and wages paid to financial intermediaries (banks, mutual and hedge funds, insurance companies, etc.) by the rest of the economy (households, non financial firms, etc.) grew from 2 percent to 9 percent of GDP from 1870 to 2010.
You might think the growth of the financial industry reflects an improvement in its services. Not exactly. I measured the output of the finance industry by looking at all issuances of bonds, stocks and loans to firms and households. The financial industry charged about 1 to 2 percent for these services for over 130 years. However, those charges have been trending upward since the 1970s.
In other words, the finance industry of 1900 was just as able as the finance industry of 2000 to produce loans, bonds and stocks, and it was certainly doing it more cheaply. This is counter-intuitive, to say the least. How is it possible for today's finance industry not to be significantly more efficient than the finance industry of John Pierpont Morgan?
One argument I often hear is that improvement in IT explains the increase in the share of finance. This argument, however, is completely misleading. An apt analogy is with retail and wholesale trade. These are intermediation services, they are heavy users of information technology, and they largely account for the revival of productivity growth in the second half of the 1990's. If there is one IT success story out there, this is it!
The difference between the retail and wholesale trade sector and the finance industry could not be more striking. As the former invested more and more in IT, its share of GDP actually decreased. Yes, this is what efficiency usually means: more for less. Based on what we see in wholesale and retail trade, IT should have made finance smaller, not larger.
What happened? Why did we get the bloated finance industry of today instead of the lean and efficient Wal-Mart? One simple answer is that technology has mostly been used to increase trading activity. Recent levels of trading activities are at least three times larger than at any time in previous history. And the cost of this activity is large. One study estimates that investors spend 0.67 percent of asset value trying (in vain) to beat the market through active trading.
Has increased trading led to either better prices or better risk sharing? I would like to believe that the answer is yes, but I am still waiting for the evidence (in fact, recent work I have been doing suggest that there has been no improvement in price quality). If the answer turns out to be no, then we would have to conclude that the finance industry's share of GDP is about 2 percentage points higher than it needs to be and this would represent an annual misallocation of resources of about $280 billion for the U.S. alone.
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