For a long time, and especially since the financial crisis, many people have suspected that financialization is bad for an economy. There is something unsettling about watching the financial sector become a bigger and bigger part of what people do for a living. After all, finance is all about allocation of resources — pushing asset prices toward their correct value so businesses can know what projects to invest in. But when a huge percent of a country’s effort and capital are put into finance, there are less and less resources to reallocate. We can’t all get rich trading houses and bonds back and forth.
Pointer from Mark Thoma.
1. Economists have no idea how to measure the value created by the financial sector. Ask any economist the following question: how should we define/measure the output of a commercial bank? You will hear the sound of crickets–even among economists who purport to study economies of scale in banking! An even more difficult question is how to measure the output of an investment bank.
2. Mathematical economics, notably the Arrow-Debreu general equilibrium model, implies that the value produced by the financial sector is exactly zero. Note Smith’s phrase “pushing asset prices toward their correct value.” This strikes me as a very truncated view of the role of financial institutions, but even so it is ruled out by Arrow-Debreu, in which prices are determined by a set of equations without any agent in the economy doing any “pushing.”
What should we conclude from (1) and (2)? One possibility is that the value of the financial sector is close to zero. The other possibility is that the cult of mathematical modeling has left economists unable to describe the role of financial institutions in the economy. My money is on this latter possibility.
Economists’ analysis of the financial sector is close to 100 percent mood affiliation. You will find many economists who are convinced that the failure of Lehman Brothers had major economic effects. You will not find a carefully worked-out verbal description of this, much less a mathematical model.
Note that I do not cheer for large banks or for mortgage securitization. My thinking on the financial sector is spelled out more in the Book of Arnold.
Here, the point I am trying to make is that not having a grasp on what financial institutions do should be an indictment of economists, not of the financial sector.
Financialized does that include lending money to developing businesses and economies? Hasn’t a financialized economy worked for Switzerland for a long time?
Noah Smith: “But when a huge percent of a country’s effort and capital are put into finance, there are less and less resources to reallocate.”
Really? Can that be “proved?”
Is “Finance” consumption? Is it a particular form of “production,” like autos, which use metals, and plastics, which are then unavailable to produce other goods.
Is “Finance” a service? Is it such that those so engaged are unavailable to render other services; what other services -auto repair, computer instruction?? If it is a service (probably) whence comes the demand; part of the AG ?
Ours is probably a “distributive economy” most activities are “linked to’ or dependent upon distribution. There is no point in making stuff that can’t be distributed. “Don’t nothin’ happen ’til somebody sells somebody somethin'”
“Finance” is part of distribution – is it not?
We can use other words like “allocation,” but we are observing distribution.
We have been, and are in, an extended period of continual (mostly political) disruptions of established and spontaneous systems of distribution by regulation of relationships and prescriptions of circumstances; much of which impacts those forms referred to as “markets.”
Back up and start over with what is affecting distribution.
This is not what I expected you to write when I saw the title of the post, and I am pleasantly surprised. These are great points.
I have seen so many academic articles that treat “financialization” as if it is causal in a series of effects that includes rising home and asset prices followed by economic stagnation or contraction. I don’t know why this is the treatment. I’m afraid your mood affiliation point is part of it.
It seems more in line with normal economic reasoning to remove the causality, and to see the entire episode as a series of trends we would expect to see when some exogenous cause has led to reduced economic expectations. That would lead to low real interest rates, which would be associated with rising real asset prices and slowing economic growth.
The financial industry naturally grows with housing prices because funding homes is a large part of their activity, and since cash flows to housing (rent) are stable, when real interest rates fall, home prices are going to rise. It’s math.
This misidentification leads to significant errors in an understanding of business cycles and secular growth.
To the extent that finance is a global service, and that some countries can be shown to have a competitive advantage in delivering financial services, Finance as a percent of GNP will always look “too high” for exporters of financial services. Perhaps we should start by tracking Global Finance as a percentage of Global GDP and see how whether this trend diverges from, say, the trend in Global Trade as a percentage of Global GDP.
I do not think it is possible to quantify the value of a supporting institution, that is, an institution that is necessary but not sufficient for the production of the broader economy. How much value does the sales department produce for a company? If the sales department does not exist, there are no sales, and the company is bankrupt. Yet it is absurd to say the sales department produces 100% of the value. The engineering and product production departments are also essential.
I think to figure out the proper size of the financial sector, you have to make subjective judgements based on a variety of data and inside knowledge. You would sort of have to guess how big the financial market would be in a free market, without TBTF, without the regulatory morass. Then the delta between that and the actual current size is the amount of waste.
Good point. The benefits of liquidity and price discovery are almost all experienced as positive externalities. This is basically what someone is saying when they say you can’t earn profits from active portfolio management.
It seems like that is what people try to do with historical prices. If we could allocate capital effectively when the financial sector was X% of the economy, why does it need to be 3 * X% today?
Is there any indication we get anything out of the extra investment? Productivity growth is lower now vs then, and the two big financial bubbles we experienced provide plenty of examples of zero sum shenanigans.
On a personal level when I look at various products and services cooked up via financial innovation in the last two decades I don’t come across many I think provide positive returns to the economy as a whole. I used to work in derivatives of increasingly complicated varieties, going into why I didn’t buy the argument that it reduced risk or any of the other reasons given for its existence would take awhile, but that’s my view on them.
My guess is that most basic financial services provided decent externalities for the economy, but that most of what we have cooked up lately is pure zero sum. My guess is we could get by with a smaller financial sector without negative impacts, much like we could get by with a smaller healthcare sector without effecting health outcomes.
I think for the most part retail financial intermediation has become much more efficient. Think of passive index funds and online brokers. Much of the increase in what counts toward gdp is compliance costs. Also, there is a lot of work in the global exchange of risk and investment which I think ends up largely as a trade between feign debt buyers and us corporations investing abroad. Those profits end up coming to the us through a sustainable trade deficit paid for with corporate profits from abroad. But the source of capital is foreign savers who value our liquid credit markets, which is basically a product of finance.
I don’t know much about the mathematical models you describe in point 2, but surely these rely on assumptions about perfect information and zero transaction costs? Isn’t the whole point of the financial industry to help bridge information asymmetries between holders of capital on the one hand and entrepreneurs and borrowers on the other, and to reduce the associated transaction costs? In other words, the financial industry is the reason the world acts as much like those models as it does.