In 1950, finance and insurance in the US accounted for 2.8 percent of GDP, according to US Department of Commerce estimates. By 1960, that share had grown to 3.8 percent of GDP, and reached 6 percent of GDP in 1990. Today, it is 8.4 percent of GDP and it is not shrinking. The Wall Street Journal’s Justin Lahart reports that the 2010 share was higher than the previous peak share in 2006.
Lahart goes on to say that growth in the finance-and-insurance share of the economy has “not, by and large, been a bad thing. Deploying capital to the places where it can be best used helps the economy grow.”
However, if the US were getting good value from the extra 5.6 percent of GDP that it is now spending on finance and insurance — the extra US$750 billion diverted annually from paying people who make directly useful goods and provide directly useful services — it would be obvious in the statistics.
At a typical 5 percent annual real interest rate for risky cash flows, diverting that large a share of resources away from goods and services directly useful this year is a good bargain only if it boosts overall annual economic growth by 0.3 percent — or 6 percent per 25-year generation.
There have been many shocks to the US economy over the past couple of generations and many factors have added to or subtracted from economic growth. However, it is not obvious that the US economy today would be 6 percent less productive if it had had the finance-insurance system of 1950 rather than the one that prevailed during the past 20 years.
There are five ways that an economy gains from a well-functioning finance-insurance system.
First, people are no longer as vulnerable to the effects of fires, floods, medical disasters, unemployment, business collapses and so forth, because a well-working finance-insurance system diversifies and thus dissipates some risks, and deals with others by matching those who fear risk with those who can comfortably bear it. While it might be true that the US’ current finance-insurance system better distributes risk in some sense, it is hard to see how that could be the case, given the experience of investors in equities and housing over the past two decades.
Second, well-functioning financial systems match large, illiquid investment projects with the relatively small pools of money contributed by individual savers who value liquidity highly. There has been one important innovation over the past two generations: Businesses can now issue high-yield bonds. However, given the costs of the bankruptcy process, it has never been clear why a business would rather issue high-yield bonds (besides gaming the tax system), or why investors would rather buy them than take an equity stake.
Third, improved opportunities to borrow allow one to spend more now, when one is poor, and save more later, when one is rich. Households are certainly much more able to borrow, thanks to home-equity loans, credit card balances and payday loans. However, what are they really buying? Many are not buying the ability to spend when they are poor and save when they are rich, but instead appear to be buying postponement of the “unpleasant financial retrenchment” talk with the other members of their household. That is not something you want to buy.
Fourth, we have seen major improvements in the ease of transactions. However, while electronic transactions have made a great deal of financial life much easier, this should have been accompanied by a decrease, not an increase, in the finance share of GDP, just as automated switching in telecommunications led to a decrease in the number of telephone switchboard operators per phone call. Indeed, the operations of those parts of the financial system most closely related to technological improvements have slimmed down markedly: Consider what has happened to the checking operations of the regional Federal Reserve Banks.