Our finance industry has grown too large

Reversals of fortune were a common occurrence long before they were discovered as a plot device by literature, movies and TV soaps. Financial adversity happened often enough to earn its own place in our culture. It had its own vocabulary and even its own humor.

In towns and especially in cities, one of the last-ditch efforts to keep things together following a reversal was “taking in laundry” — washing and ironing the clothing of more fortunate people. It was a way to provide the household with some cash income and the practice was especially common in the U.S. during the 1930s Depression.

Long after the Depression was over, the term lived on in a popular joke about a shipwrecked group of people who found themselves stranded on a desert island —but managed to eke out a living by taking in each other’s laundry. The joke later acquired a second life when the castaways in the story were identified as economists, a group often criticized for not understanding how a real economy actually works.

The absurdity of an economy, desert island or not, functioning effectively by simply transferring one person’s work to another cut to the core of measuring our economic growth and progress by adding up transactions. And despite largely successful efforts to refine our Gross Domestic Product to reflect only net value added, that criticism has never really abated.

The national accounting system, on which GDP calculations are based, relies on market prices and valuations for its validity. It does an excellent job of measuring that but leaves many open questions about what else, if anything, should be measured in an economic system. It is a very short distance, for example, from the economists-on-the-desert-island story to the more serious question of how the activities of parenting and home-related labors should be valued.

The underlying assumption of the GDP calculation is that the free market sorts out any valuation problems and that the price of any product or service, then, reflects its value. That is a practical, valid and defensible assumption and has served us very well over many years.

GDP is not the only lens to look through when we examine our economy, though. One of the key non-market values in an economy, for example, is good parenting, We are becoming aware of its value primarily due to the very real, visible and measurable public costs of bad parenting — most visibly in education, medicine, crime and productivity.

What GDP doesn’t measure is only part of the problem in economics. Even what it does measure very well raises questions that economics cannot answer. The central one is this: What is the optimum relative size of a sector? What proportion of our economic activity should be devoted to, say, finance, in order to promote maximum economic growth? If there is an optimum size or proportion for the financial sector, for example, we do not know what it is.

In a 2011 research paper, entitled “The Size of the U.S. Finance Industry: A Puzzle?” Thomas Philippon, a professor of finance at New York University, examined the growth of our financial sector in terms of its size. He looked at its expanding share of our national income and also calculated the costs of the services it delivered.

What he found is that since 1940, the financial sector’s share of our national income has more than doubled and, consequently, the cost of the services provided by this sector had increased substantially. As he states it, “The model suggests that the US financial system has become less efficient over time: the unit cost of intermediation is higher today than it was a century ago. Improvements in information technology have been cancelled by increases in trading activities whose aggregate social value is difficult to measure.”

The trading referred to by Professor Philippon is not just the activity engaged in by our giant banks, whose multi-billion dollar gambling losses have made headlines, but also the buying and selling of stocks by individuals, funds and institutions. We have become a nation of speculators.

“The Size of the U.S. Finance Industry: A Puzzle?” could be, on its own, a textbook for a course in modern economics, at once revealing how far our knowledge has come and an acknowledgement of how much we have yet to learn.

It is becoming clear that the market system cannot guarantee that growth of any given sector will stop at its optimum size. It is likely that we already devote too much of our resources to financial services, and quite possibly to health care, also.

Despite the unanswered questions in economics one thing is certain. We cannot all make a living by selling each other stocks and bonds.

James McCusker is a Bothell economist, educator and consultant. He also writes a column for the monthly Herald Business Journal.

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