November 14, 2022
I remember talking to a progressive group a bit more than a decade ago, arguing for the merits of a financial transactions tax (FTT). After I laid out the case, someone asked me if we had lost the opportunity to push for an FTT now that the financial crisis was over. I assured the person that we could count on the financial sector to give us more scandals that would create opportunities for reform.
Shortly after, we were rewarded with the trading scandal from the aptly named investment company, MF Global. It seems that FTX has given us yet another great case study of greed and corruption in the financial sector.
The financial sector was and is a happy home for those seeking big bucks and who don’t mind bending or breaking the rules to fill their pockets. Corporate America is not generally known as a center of virtue, but in most other sectors, there is at least a product by which a company can be evaluated. Does the auto industry produce cars that are safe and drive well? Does the airline industry get people to their destinations on time?
These are metrics that can be applied in a reasonably straightforward way. But what does the financial sector do? In fact, there are metrics, but they are not as straightforward, and we literally never see the business press applying them to the sector.
Finance and Trucking: Big is Bad
At the most basic level, finance is an intermediate good. This distinguishes the financial sector from sectors like health care, housing, or agriculture. Finance does not directly produce anything of value to households. Its value to the economy is that it facilitates transactions and allocates capital. These functions are tremendously important, but they are not valuable in themselves. They are valuable because of their service to the productive economy.
In this way, finance can be considered similar to the trucking industry. Trucking is enormously important to the economy in getting goods to consumers and essential inputs to manufacturers and service providers. But it does not directly produce value. We only benefit from having more workers and trucks if they allow the industry to serve its function better. That means getting goods to their destination more quickly or getting them there with less damage or spoilage.
This is the same story with finance. We benefit from having more resources in finance only insofar as they allow it to service the productive economy better. That means facilitating payments to make them easier and quicker and better allocating capital to its most productive uses.
Serious Bloat in Finance
The financial sector has exploded in size in the last half-century. The broad finance, insurance, and real estate sector has more than doubled as a share of GDP over the last half-century, increasing from 5.5 percent of GDP in 1971 to 12.0 percent in 2021. The additional 6.5 percent of GDP being devoted to finance in 2021 is equivalent to more than $1.4 trillion being absorbed by the sector. This comes to more than $11,800 a year for an average family.
The more narrow securities and commodity trading sector, along with investment funds and trusts, more than quadrupled as a share of GDP, rising from 0.55 percent of GDP in 1971 to 2.56 percent in 2021. This increase of 2.0 percentage points of GDP comes to more than $500 billion a year in the current economy, or almost $4,400 a year per family. This is more than half the size of the military budget.
Clearly, the financial sector is a far larger drain on the economy today than fifty years ago. It is also a major source of inequality. The list of the country’s billionaires is chock full of people, like Stephan Schwarzman and Peter Thiel, who made fortunes in hedge funds, private equity funds, and other financial entities. In short, the data are clear: the financial sector is taking up a far larger share of the economy’s resources than it did a half-century ago, and it is a major factor in generating inequality,
The big question is, what are we getting for all the extra resources the financial sector is taking from the rest of us? This is asking about the extent to which our means of payments have been improved and the extent to which we better allocate capital today than we would be with a smaller financial sector.
On the first question, clearly we have developed better mechanisms for paying our bills and carrying on other transactions, but the biggest developments are hardly new. Direct deposit of our paychecks and automatic payments for bills are great innovations that save lots of time for both sides of the transactions. However, these innovations date back more than four decades.
The same holds with credit cards and debit cards. The overwhelming majority of transactions are now made with these cards, but this is not especially new technology. Credit cards were already widely available in 1971, even if they were nowhere near as ubiquitous as they are today.
We can give the financial sector credit for the increase in the convenience of our system of payments, but how much is this worth? Is the time saved from using credit cards or having a direct deposit of your payments worth $11,800 a year to you? That seems a bit steep. I suspect given the option, most people would prefer an extra $11,800 in their paycheck and be given the check by hand rather than having it deposited automatically in their bank account.
How about the other part of the financial sector’s function, allocating capital to its best uses? There is no simple way to evaluate how effective our enlarged financial sector has been in allocating capital, primarily because we don’t have a counterfactual. We can’t point to an America with a smaller financial sector over the last half-century. (Steven Cecchetti and Enisse Kharroubbi did a cross-country analysis which found a larger financial sector boosted growth, but after reaching a certain size relative to the economy, it was a drag on growth.)
We can make a comparison of productivity growth in recent decades with productivity growth in the decades before the financial sector was consuming such a large share of the country’s output. In the years from the beginning of the Bureau of Labor Statistics productivity series in 1947 to 1972, productivity growth averaged 2.8 percent annually. From 1972 to 2022, productivity growth averaged just 1.8 percent.
If anything, productivity growth has slowed further as the financial sector has expanded relative to the economy. While there was a strong decade of productivity growth from 1995 to 2005, in the years from 2005 to 2019, productivity growth averaged just 1.4 percent.
The expanded financial sector may not be responsible for the slowing of productivity growth, and it’s certainly possible that it would have slowed even more without a larger financial sector. But, it is not easy to make the case that the financial sector has somehow led to faster productivity growth.
FTX, Crypto, Rent-Seeking, and Fraud
Suppose the growth of the financial sector has not led to corresponding benefits to the productive economy. In that case, we should view it as a source of waste and inefficiency, just as we would view a massive increase in the size of the trucking industry without any benefits in terms of improved delivery times. From the standpoint of policy, we should be looking at every opportunity to whittle down the size of the financial sector to reduce waste in the economy.
Applying a financial transactions tax, similar to the sales tax paid in other sectors, would be a great place to start. Getting rid of tax preferences that provide government subsidies to private equity and hedge funds is another great policy option. Also, simplifying the corporate tax code to reduce the money made by tax gaming should also be a priority.
As a general rule, we should be doing everything possible to reduce the size of the financial sector, as long as we are not jeopardizing its ability to serve the productive economy. The message here for dealing with crypto should be very clear.
There is zero reason to encourage the growth of crypto. If people want to play around with crypto, that is their right, just like people can gamble at casinos or horse races. But the idea that the government should look to foster the growth of crypto, as many politicians have advocated, would be like the government encouraging alcohol or tobacco addiction.
While crypto may help facilitate criminal transactions (apparently this is no longer clearly true), it serves no legitimate purpose. In a world of scammers, it should not be surprising that we would see a sham exchange like FTX that seems to have defrauded its customers big time.
The proper government response is not to encourage people to gamble in crypto by regulating the industry and making it safer for ordinary people to throw their money in the toilet. The proper response is to throw the fraudsters in jail and tell people they invest in crypto at their own risk. If they want to engage in honest gambling, let them go to Vegas.
If our politicians actually had any interest in economic efficiency, they would be engaged in an all-out push to downsize the financial industry and free up hundreds of billions of dollars for productive uses. Unfortunately, their flirtation with crypto scammers is a symptom of the larger problem. The finance industry has bought their collaboration, and politicians of both parties will continue to run interference for the financial industry as long as the campaign contributions are coming in.
 These data are taken from National Income and Product Accounts Table 6.2B, with the total share being Line 52 divided by Line 1 for 1971 and Table 6.2D, Lines 57 and 62, divided Line 1 for 2021. For the narrow securities and commodity trading sector, and holding and trust accounts, the calculation uses Line 55 and Line 59, divided by Line 1 for 1971. For 2021, it uses Line 59 and Line 61, divided by Line 1. These tables only give data on labor compensation. The implicit assumption is that the industry’s value added is proportional to labor compensation in the sector. While this will not be precisely accurate, it should be reasonably close.