Thomas Philippon, a New York University economist, has reached the remarkable conclusion that despite having gobbled up the American economy—total compensation in the financial sector (profits, wages, and bonuses) now represents an unprecedented 9 percent of GDP—Wall Street is no more efficient at “transferring funds from savings to borrowers” than it was in 1910, when finance’s share of the GDP was about half what it is today. Indeed, when you factor in cost per dollar of assets created Wall Street is somewhat less efficient:
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?
This finding is particularly astonishing given the huge impact that computers have had on the economy in general and on financial industries in particular. What Philippon found was that “technological improvements in finance have mostly been used to increase secondary market activities, i.e., trading.” Trading is way, way up (Philippon estimates its level is at least three times greater than at any previous time in history), and the cost of trading is way, way down. But Philippon finds “no evidence that increased liquidity has led to better (i.e., more informative) prices or to more insurance.” Stock prices relative to company assets are no better at signaling the likelihood of future earnings growth than they were the day the Titanic sank, and risk management is a good deal worse. What trading is mainly good for is making Wall Street banks rich.
Technological improvement such as computerization is supposed to lower an industry sector’s share of GDP, not raise it. Take retail. Wal-Mart uses technology to increase sales volume, but the more it does so the more it drives down profit margins—its own and everybody else’s. The same logic does not appear to hold for Goldman Sachs. As the finance industry has ramped up its use of computers it has increased its profits and enlarged its share of GDP. As a result, the non-financial part of the economy is shrinking relative to the financial sector.
The country is putting a lot more of its collective resources into Wall Street but it doesn’t have much to show for it. “The finance industry that sustained the expansion of railroads, steel and chemical industries, and the electricity and automobile revolutions,” writes Philippon, “was more efficient than the current finance industry.” By “current” Philippon means as of 2010, so don’t even think about blaming this on the Dodd-Frank financial reform bill, which was signed into law in July of that year. A much likelier culprit than regulation is the deregulation that occurred during the prior three decades.
Philippon concludes from his calculations that the finance industry’s share of GDP is about 2 percentage points higher than it should be and that this 2 percent constitutes “an annual misallocation of resources of about $280 billion for the U.S. alone.” Instead of fretting about taxes levied by the government, maybe we should worry about the tax levied by Wall Street.