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.