Last Tuesday, The Century Foundation was honored to host Alan Blinder, renowned economist and recent editor (alongside Andrew Lo and Robert Solow) of Rethinking the Financial Crisis; a compilation of new research challenging the conventional wisdom on Wall Street about the efficiency of financial markets and the rationality of the investors who speculate in them.
The story Professor Blinder told was a familiar one: Decades of “financialization”—a term economists use to describe the growing scale, profitability and deregulation of the financial sector relative to the “real economy”—allowed banks to become too big, too speculative, and too opaque in the years leading up to the financial crisis. Even with the passage of the Dodd-Frank regulatory reforms, financial institutions like Bank of America, Citigroup and JPMorgan Chase remain “too big to fail.”
The growth of the financial industry has been a boon for its highly-paid managers. According to New York University economist Thomas Philippon, who contributes one of the most striking chapters in Rethinking the Financial Crisis, “total compensation of financial intermediaries (profits, wages, salary and bonuses) as a fraction of GDP is at an all-time high, around 9% of GDP.”
To give those numbers some context, consider that 9 percent of US GDP last year was about $1.4 trillion—an unprecedented windfall for America’s capitalist class. “What does society get in return? Or, in other words, what does the finance industry produce?”
Historically, the unit cost of intermediation has been somewhere between 1.3% and 2.3% of assets. However, this unit cost has been trending upward since 1970 and is now significantly higher than in the past. In other words, the finance industry of 1900 was just as able as the finance industry of 2010 to produce loans, bonds and stocks, and it was certainly doing it more cheaply. This is counter-intuitive, to say the least. How is it possible for today’s finance industry not to be significantly more efficient than the finance industry of John Pierpont Morgan?
The short answer is that Wall Street, for the last thirty years or so, has been skimming prodigiously from the top. The graph above shows how the total economic cost of financial intermediation grew from under 2 percent in 1870 to nearly 6 percent before the stock market collapsed in 1929. It grew slowly throughout the postwar expansion, reaching 5 percent in 1980. Then, beginning during the deregulatory years of the Reagan administration, the money flowing to financial intermediaries skyrocketed, rising to almost 9 percent of GDP in 2010.
This is exceptionally counter-intuitive, as Philippon points out. Over the last forty years, information technology has increased efficiency and lowered costs throughout the economy. Retail and wholesale trade, for instance, have both shrunk by about 20 percent as a share of GDP since 1970, thanks to better technology and improved economies of scale.
The cost of financial intermediation, meanwhile, continues to reach record highs. “According to this measure,” writes Philippon, “the finance industry that sustained the expansion of railroads, steel and chemical industries, and the electricity and automobile revolutions was more efficient than the current finance industry.”
Part of this discrepancy is explained by soaring trading volume: Philippon estimates the level of “secondary market activities, i.e., trading” is more than ten times its 1960s level, and several times higher than the late 1990s. This has lowered certain trading costs, allowing more people to buy stocks online, for example.
But Philippon finds “no evidence that increased liquidity has led to better (i.e., more informative) prices or to more insurance [i.e., less risk].” In other words, the average retail investor is just as likely to get manipulated by the big investment banks as ever before. In fact, if recent history is any indication, the odds of “beating the market” are even worse: 50 to 70 percent of trading volume is now the result of high-frequency trading by corporate supercomputers, which use sophisticated computer algorithms to buy and sell securities within the span of seconds or milliseconds. Even ordinary Americans who play it safe by investing their retirement savings with mutual funds often find themselves getting fleeced by hidden fees and commissions.
All together, Phillipon calculates the excess income consumed by the finance sector totals 2 percent of GDP, “an annual misallocation of resources of about $280 billions for the U.S. alone.” If accurate, that figure suggests an extraordinary redistribution of the national wealth—from the pockets of the debtors and middle class investors who need it most, straight into the bank accounts of America’s financial elite.