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More on whether finance is too big

by Robert Teitelman | Published March 5, 2012 at 1:06 PM

Two papers by New York University economist Thomas Philippon (hat tip: James Kwak at The Baseline Scenario) cast a weak, but necessary light on one of the central issues of the age: Is finance too big or too dysfunctional? Philippon has built equilibrium models that compare the financial sector to the overall economy over a number of decades. In a November 2008 paper, "The Evolution of the U.S. Financial Industry from 1860 to 2007: Theory and Evidence," he offers up a model that "separates supply and demand factors in the market for financial intermediation." Then, in a paper from November 2011, "Has the U.S. Financial Industry Become Less Efficient?," he tries to calculate the cost of intermediation and the production of assets and "liquidity services." He concludes, surprisingly, that the costs are higher, thus rendering finance less "efficient." The reason: For all the cost-savings brought on by improvements in information technology, they have been outstripped by the growth of trading activities "whose social value is difficult to assess."

There's a lot here. Philippon is speaking to a broader set of issues that has grown particularly important in the wake of the financial crisis: Is the relatively enormous size of the financial sector, certainly compared to, say, the '50s or '60s, a good thing or bad? What has really driven that "financialization"? Is finance simply larger because of the shift to services from manufacturing, accelerated by advances in information technology and by globalization? Or is it because of the explosion in trading? Is the growth of finance (which seems to mean everything from Wall Street to banking to money management) a zero-sum game with the real economy? Or does the growth of finance accompany and drive larger changes in the real economy, like technology, globalization and the breakdown of the hegemony of the large, stable corporation? These questions are central to developing an underlying philosophy of regulation that informs policy. What might be the effect on the real economy (or on specific sectors of that varied landscape) if you broke up the big banks and forced finance to shrink, as occurred in the post-Great Depression period? These are currently unanswerable, except in the most sketchily circumstantial ways, by economists, who have not spent a lot of time (as Philippon clearly has) thinking about the relationship of the size and nature of financial intermediaries to growth in the real economy.

Part of the reason no one has effectively tackled that seemingly large and pressing question is that so many factors go into all this. Does agriculture or manufacturing demand a different kind, and size, of finance? Does global competition demand a different kind of financial sector than, say, one in which competition occurs mostly domestically? What role do information technologies play? What role does classic intermediary services, such as advice, play, as compared with speculation and trading? Philippon admits that he has built "a simple equilibrium model." In fact, most of these papers consist of a heavily mathematical description of the model. This is no knock on Philippon; you use what's available. But some of these relations and measures he trots out may not in reality be as clear as he suggests. In short, some skepticism is in order.

Still, he offers several conclusions that do seem plausible. Yes, the role of finance in economic activity does vary over time, he concludes in the 2008 paper. In other words, finance fluctuates in size relative to the real economy. He quickly knocks down the notion that financial expansion is somehow tied to productivity growth in the nonfinancial sector. "Neither financial globalization, nor increased trading of securities, nor the development of the mutual funds industry can account for the increasing share of finance in GDP." Philippon argues "finance is important when firms with low cash flows also have the best investment opportunities." That is, when the economy has a relatively larger share of startup or newer companies, as compared to high-cash-flow giants, a large, or more efficient finance sector is more important to nurture it. This, in fact, is exactly the kind of real economy that evolved in the '70s, breaking the dominance of large corporations that had been on top since the '30s. That having been said, Philippon remains puzzled by the continued growth of finance as a percentage of GDP from 2002 to 2007, after the dot-com bust and just before the financial crisis, which far exceeded anything in the real economy.

In his more recent paper, Philippon focuses more on the cost and efficiency of intermediation. Again, he discovers variations, from 2% to 6% of GDP from 1870 to 1930, when it falls to less than 4% in 1950 and 5% in 1980. Then it takes off again, hitting almost 9% in 2010. Moreover, in a separate exercise, Philippon attempts to quantify the cost of intermediation. For the most part, that cost ranges from 1.3% to 2.3% for some 130 years, only to escalate in the '70s. Finance accounted for not only an unusually large portion of GDP; it was also more costly, and less efficient. This raises a big question for Philippon: How do you explain this, particularly in light of the efficiency advances of information technologies? In theory, he says, IT should shrink finance, and reduce its cost, by making it more productive. Instead, both have grown. Philippon points to the vast expansion of trading activities, driven by falling costs, as a major reason, and asks an excellent question. Does all that trading lead to a potential benefit in the form of better price discovery and risk sharing?

That's another question many claim to know the answer to, but that few can effectively prove empirically. In fact, every question of regulation or re-regulation seems to be reflexively accompanied by grave warnings about liquidity, another way of saying price discovery. If you drive derivatives to clearinghouses you could dry up liquidity. If you impose the Volcker Rule on U.S. banks, you threaten liquidity, most famously of European and Canadian sovereign issues. If you restrict speculation or restrain certain derivatives, you threaten risk management. Some of this may even be true, which makes answering that question pretty important. Again, however, Philippon's papers should be taken with a healthy degree of skepticism. Philippon deserves credit for wading into areas that are both increasingly central and rarely traveled. These are difficult questions to answer, and, relative to the daunting realities of the real world, his tools are relatively primitive. But he is at least asking the questions and making the effort. For now, he provides a small, secure foothold in a treacherous hillside. - Robert Teitelman

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