Noah Smith has a great post that bears on the topic that I have been discussing of late (here and here): whether the growth of the US financial sector over the past three decades had anything to do with the decline in the real rate of interest that seems to have occurred over the same period. I have been suggesting that there may be reason to believe that the growth in the financial sector (from about 5% of GDP in 1980 to 8% in 2007) has reduced the productivity of the rest of the economy, because a not insubstantial part of the earnings of the financial sector has been extracted from relatively unsophisticated, informationally disadvantaged, traders and customers. Much of what financial firms do is aimed at obtaining an information advantage from which profit can be extracted, just as athletes devote resources to gaining a competitive advantage. The resources devoted to gaining informational advantage are mostly wasted, being used to transfer, not create, wealth. This seems to be true as a matter of theory; what is less clear is whether enough resources have been wasted to cause a non-negligible deterioration in economic performance.
Noah underscores the paucity of our knowledge by referring to two papers, one by Robin Greenwood and David Scharfstein (recently published in the Journal of Economic Perspectives) and the other, a response by John Cochrane posted on his blog (see here for the PDF). The Greewood and Scharfstein paper provides theoretical arguments and evidence that tend to support the proposition that the US financial sector is too large. Here is how they sum up their findings.
First, a large part of the growth of finance is in asset management, which has brought many benefits including, most notably, increased diversification and household participation in the stock market. This has likely lowered required rates of return on risky securities, increased valuations, and lowered the cost of capital to corporations. The biggest beneficiaries were likely young firms, which stand to gain the most when discount rates fall. On the other hand, the enormous growth of asset management after 1997 was driven by high fee alternative investments, with little direct evidence of much social benefit, and potentially large distortions in the allocation of talent. On net, society is likely better off because of active asset management but, on the margin, society would be better off if the cost of asset management could be reduced.
Second, changes in the process of credit delivery facilitated the expansion of household credit, mainly in residential mortgage credit. This led to higher fee income to the financial sector. While there may be benefits of expanding access to mortgage credit and lowering its cost, we point out that the U.S. tax code already biases households to overinvest in residential real estate. Moreover, the shadow banking system that facilitated this expansion made the financial system more fragile.
In his response, Cochrane offers a number of reasons why Greenwood and Scharfstein are understating the benefits generated by active asset management. Here is a passage from Cochrane’s paper (quoted also by Noah) that I would like to focus on.
I conclude that information trading of this sort sits at the conflict of two externalities / public goods. On the one hand, as French points out, “price impact” means that traders are not able to appropriate the full value of the information they bring, so there can be too few resources devoted to information production (and digestion, which strikes me as far more important). On the other hand, as Greenwood and Scharfstein point out, information is a non-rival good, and its exploitation in financial markets is a tournament (first to use it gets all the benefit) so the theorem that profits you make equal the social benefit of its production is false. It is indeed a waste of resources to bring information to the market a few minutes early, when that information will be revealed for free a few minutes later. Whether we have “too much” trading, too many resources devoted to finding information that somebody already has in will be revealed in a few minutes, or “too little” trading, markets where prices go for long times not reflecting important information, as many argued during the financial crisis, seems like a topic which neither theory nor empirical work has answered with any sort of clarity.
Cochrane’s characterization of information trading as a public good is not wrong, inasmuch as we all benefit from the existence of markets for goods and assets, even those of us that don’t participate routinely (or ever) in those markets, first because the existence of those markets provides us with opportunities to trade that may, at some unknown future time, become very valuable to us, and second, because the existence of markets contributes to the efficient utilization of resources, thereby increasing the total value of output. Because the existence of markets is a kind of public good, it may be true that even more market trading than now occurs would be socially beneficial. Suppose that every trade involves a transaction cost of 5 cents, and that the transactions cost prevents at least one trade from taking place, because the expected gain to the traders from that trade would only be 4 cents. But since that unconsummated trade would also confer a benefit on third parties, by improving the allocation of resources ever so slightly, causing total output to rise by, say, 3 cents, it would be worth it to the rest of us to subsidize parties to that unconsummated trade by rebating some part of the transactions cost associated with that trade.
But here’s my problem with Cochrane’s argument. Let us imagine that there is some unique social optimum, or at least a defined set of Pareto-optimal allocations, which we are trying to attain, or to come as close as possible to. The existence of functioning markets certainly helps us come closer to the set of Pareto optimal allocations than if markets did not exist. Cochrane is suggesting that, by devoting more resources to the production of information (which in a basically free-market, private-property economy involves the creation private informational advantages) we get more trading, and with more trading we come closer to the set of Pareto-optimal allocations than with less trading. However, it seems plausible that the production of additional information and the increase in trading activity is subject to diminishing returns in the sense that eventually obtaining additional information and engaging in additional trades reduces the distance between the actual allocation and the set of Pareto-optimal allocations by successively smaller amounts. Otherwise, we would in fact reach Pareto optimality. So, as we devote more and more resources to producing information and to trading, the amount of public-good co-generation must diminish. But this means that the negative externality associated with using increasing amounts of resources to produce private informational advantages must at some point — and probably fairly quickly — overwhelm the public-good co-generated by increased trading.
So although Cochrane has a theoretical point that, without more evidence than we have now, we can’t necessarily be sure that the increase in resources devoted to finance has been associated with a net social loss, I am still inclined to suspect doubt strongly that, at the margin, there are net positive social benefits from adding resources to finance. In this regard, the paper (cited by Greenwood and Scharfstein) “The Allocation of Talent: Implications for Growth” by Kevin Murphy, Andrei Shleifer and Robert Vishny.
Uneasy Money 
I like this post, but I do have one slight issue. You talk about a set of “Pareto optimal allocations”…but Pareto optimality is not well-defined when you allow production technology to vary. Do you measure efficiency relative to the situation where all possible technology is known? Do you measure efficiency relative to the situation where humans have discovered the most technology they could discover given their history and resources? Both of those are totally unobservable.
If finance increases TFP but creates inefficiencies in the system, you have to balance those against each other. GDP seems to be the obvious criterion, but of course how do you determine a counterfactual?
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“the decline in the real rate of interest”
Really? Go to FRED, take a look at, say, the Baa bond rate adjusted for inflation. You’ll see that while it has come down somewhat since the early 1980s, it has been consistently higher over the past 25 years than in the 1950s, 1960s and 1970s.
The risk-free overnight rates have declined. Risky long rates have not.
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How about exploring the Social Cost of Regulatory Capture instead?
To the extent finance has grown larger in due to an older and wealthier society, that’s positive.
To the extent finance has benefitted from regulatory arbitrage, in part due to regulations written by lobbyists, that’s bad. But this isn’t exactly a problem unique to the financial sector.
A lot of the increase in trading has occurred because the cost of trading is basically zero, not because informational advantages are large. If the denominator goes to zero… well, you do the math. I don’t think trading employs a very significant percentage of the population.
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David, if you’re right, what a sad outcome. So many people wasting their time.
What about the hedging role that options, derivatives, and other financial instruments offer to society? In some ways, these instruments act very much like insurance. Traders spend large amounts of time trying to calculate the right prices on these instruments — time which might be better spent doing socially useful things, as you point out. But this frees insurance companies from the necessity of allocating scarce company time to providing various types of hedging instruments and “discovering” correct prices.
Of course, I sometimes wonders how often derivatives are actually used as insurance and not just highly-leveraged speculative instruments.
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Noah, Thanks. You raise an interesting question that I have no answer for. My argument was intuitive and heuristic, so I am sorry, but I don’t have a definition of Pareto optimality that I can provide you with to make my argument more intelligible. It might be doable, but someone else will have to do it. If you are experiencing a sense of déjà vu as you are reading this, it’s not just a coincidence, because I am experiencing déjà vu all over again writing it. 🙂
JW, Good point, and certainly worth pondering, but that doesn’t mean that the decline in the riskless real interest is of no importance. What’s your take?
Steve, This discussion is speculative, so I am not claiming that the theoretical effect that I am highlighting explains anything empirically. I am just trying it out on readers and hoping to get people thinking and talking about it. My problem is not so much with the trading as it is with the resources devoted to gaining informational advantages to be used in extracting profits at the expense of other less informed traders. Cochrane wants to say that all the trading is good, so the resources devoted to gaining the information that generates the trading is not necessarily wasted. I was trying to respond to Cochrane’s argument justifying the expenditure of time, effort and resources to acquire informational advantages.
JP, I am not saying that these activities have no social benefit. The argument is that they are overproduced, not that they shouldn’t be produced at all.
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The first time you brought up this topic, you gave the context of Veblen’s view of finance as purely parasitic (you cited, I think, The Engineers and the Price System, but nearly all his works contain language to that effect). Since some of the claims about the financial sector’s social value are so extreme in the other direction, I do like the Veblen perspective to be kept in view, if only to illustrate the range of possible answers.
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I also worry about the distributional effects of widespread financial investment in the housing sector, which I fear bids up land values, increases rents of people who can’t choose to raise their income level, and fosters instability. I am aware that this is an outlandish and unseemly worry to have, and one unwelcome in economics discussions.
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Will, I am not really a big fan of Veblen, a severe critic of neoclassical economic theory, but I thought that it was appropriate to point out that he had articulated a view of finance that may have anticipated the theoretical insight of my teacher Jack Hrishleifer, a superb neoclassical economist. Don’t worry, you’re welcome to share outlandish and unseemly ideas here any time.
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From a naive perspective, Finance is in the business of allocating resources. Doing this costs resources. This cost we can consider as proportional to the size of Finance. It used to be, long ago, that this cost was 3%. Then it was 5%, and now it is 8%. If other things were equal, we might expect growth to be proportional to the efficiency of the allocation of resources. If this efficiency were proportional to the size of Finance, we would expect ever higher rates of growth as Finance grew. Do we see this? Or do we see a gradual decline in growth as Finance has grown in recent years?
From a different perspective, have we seen Finance allocate resources for social efficiency, or for its own, and its officer’s, benefit?
Finally, Finance, in allocating real resources, makes loans to the real economy. The return on these loans is the only way it draws real resources to itself. (The activity it does internally is, to the real economy, merely the churning of financial assets.) The return on these loans must be proportional to the size of Finance, in order to support Finance. This return to Finance is demand taken from the real economy, unless re-loaned. Clearly, when the indebtedness of the rest of the economy to Finance is too great, paying back the loans to Finance drives out the ability of the rest of the economy to invest in itself, that is to grow and, taken to an extreme, even maintain itself.
Indeed, under these circumstances, were Finance to demand the full payment of its loans to the real economy, we would first expect the destruction of the real economy. And Finance, too, although as they have some of the highest cabins, they would experience the flooding last.
See:
http://anamecon.blogspot.com/2010/06/that-bloated-financial-sector.html
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The reader might also want to check out Yves Smith’s expose of the foreclosure scandal over at Naked Capitalism for a concrete example of the current cost of Finance to the rest of the economy.
http://www.nakedcapitalism.com/2013/01/37705.html
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I’m glad we have financial markets or I would not have found my passion. I certainly love finance and it’s economics. I will certainly go ahead and read that paper about talent. In the end it’s all about the people, and it’s skills. It will put a nation fare ahead than others.
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Greg, The mere fact that finance is involved in the allocation of resources rather than in using resources to make stuff doesn’t prove that it is not productive. If that were the case, then all trading activities, middlemen, wholesalers, all the people in the middle of the supply chain would be unproductive. I don’t think that’s the right way to think about it. Taking a resource from a lower valued use to a higher valued use is productive. Finance is not inherently unproductive, as Veblen seems to have thought. However, the resources used to obtain information that allows better prediction of prices are largely wasted, because there is little effect on the allocation of resources apart from the use of resources to gain the information, but there is a transfer from the worse informed to the better informed. So all resources devoted to generating wealth transfers are a social waste. My conjecture – and it is only a conjecture – is that an increasing amount of what has gone on in recent years inside financial firms has been the pursuit of informational advantage. If I am right, there has been a huge waste of resources. But an increase in the size of the financial sector does not by itself prove that the increased use of resources by the financial sector has been a waste. There could have been an increase in the demand for financial services. If more resources were necessary to meet the increase in demand, the resources were not wasted. So we need some careful empirical studies to try to find out exactly what the financial sector has done with all the extra resources that it has been using.
Tas, You are an optimist. Good luck.
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David Glasner:
From the original post:
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This is my point of view. Granted, in the transferring of wealth, sometimes value is added. But this is rather the same sort of value added provided by a truck, in rearranging goods, as opposed to a factory, or a farm, or a mine, in creating those goods. And in the rearranging of assets, value is not necessarily added, as when a fund manager, or a broker, churns his clients’ accounts.
From your comment:
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This is true, but there is a problem. Two actually. The second is that just because resources go to meet some demand, that does not mean they are not wasted. This may be a rather eccentric perspective, suggesting that the price mechanism does not always work to society’s advantage. Suppose we have a handful of wealthy financiers, who control a disproportionate share of an economy’s wealth, and spend it all on yachts, when that economy labors under the burden of increasingly obsolete infrastructure. Is that an efficient allocation of society’s resources? The free market would say so.
But the first problem is that that demand for financial services can be manipulated, and is, by the financial sector itself. The financial sector controls the flow and supply of money, and by controlling the supply of money, they control the demand for their services. The financial sector controls the supply of money through the issuing of loans. The important factor here is the ratio of interest, or actually total bank income, to bank expenditures. If this ratio is greater than one, the money supply in the real economy will contract unless the banks issue more loans. (We assume the absence of government simply issuing the stuff.) From society’s point of view, which is that of the borrowers, unless they can borrow more money, some of them will default. Thus, to avoid default, there must be more borrowing. Someone, to avoid default, must borrow. This leads to a never ending spiral of debt, and an ever larger financial sector, supported by that debt.
(These days we have the government taking up this burden.)
The only way this debt spiral can be deconstructed, and for the financial sector to be brought down to size, is for the banks to operate, for a time, with expenses greater than income. Unless a total indebtedness, in the US, of $50 to $60 Trillion is necessary for an efficient allocation of the economy’s resources. That I don’t believe to be true.
See: http://anamecon.blogspot.com/2010/11/banks-are-forcing-debt-on-rest-of-us.html
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OOPS! The eliminated the enclosed quotes!
The quote from the original posting is: “The resources devoted to gaining informational advantage are mostly wasted, being used to transfer, not create, wealth.”
The quote from David Glasner’s comment is: “But an increase in the size of the financial sector does not by itself prove that the increased use of resources by the financial sector has been a waste. There could have been an increase in the demand for financial services. If more resources were necessary to meet the increase in demand, the resources were not wasted”
Sorry.
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