Finance's shrinking piece of the pie

This year just keeps getting worse for the financial industry. As if the crash and the TARP fiasco weren’t enough to dent their public image, Congress and the Obama administration have maintained a constant barrage of criticism. Earlier this week, the President excoriated hedge funds for holding out during bailout negotiations, stating:

I don't stand with them. I stand with Chrysler's employees and their families and communities. I stand with Chrysler's management, its dealers and its suppliers. I stand with the millions of Americans who own and want to buy Chrysler cars. I don't stand with those who held out when everybody else is making sacrifices.

While it remains to be seen if the courts will uphold the government’s prepackaged bankruptcy, the public damage to the industry has been done. In a far ranging interview with the New York Times Magazine, President Obama made it clear that he expects the financial industry to shrink in the near term, either as a result of natural economic rebalancing or due to specific government actions:

What I think will change, what I think was an aberration, was a situation where corporate profits in the financial sector were such a heavy part of our overall profitability over the last decade. That I think will change. And so part of that has to do with the effects of regulation that will inhibit some of the massive leveraging and the massive risk-taking that had become so common… Wall Street will remain a big, important part of our economy, just as it was in the ’70s and the ’80s. It just won’t be half of our economy.

Whatever one believes the relative merits (or inequities) of the financial sector to be, Wall Street represents nowhere near half the economy. Clearly the president was speaking figuratively, but his comments highlight a misperception that many people have in the country- that going into the crash the financial sector was the biggest part of our economy, and that it was too large by orders of magnitude. In reality, the financial sector has never been a majority or even a plurality of the U.S. economy, nor has it been all that overpaid. According to Thomas Philippon, a professor at NYU Stern and a leading researcher on this subject, the financial sector as a percentage of GDP grew from 2.5% in 1947 to roughly 8% in 2008. During that time period, the percentage of wages capture by the financial sector was consistently higher than its contribution to GDP, but rarely strayed by more than a percentage point.

By contrast, during that same time period, the government’s share of the government has risen from 20% to nearly 35%, representing a smaller relative increase, but a nominal increase that is twice the size of the entire finance sector.

So why did the financial sector grow so much, and what is the "optimal" size? Philippon presents an intriguing argument for the rapid post-war growth of the financial services industry. According to his research, the growth was fueled by an increase in the corporate finance sector, which was responding to increased demand for financial intermediation services. This increased demand for intermediation services stemmed from a shift in the types of investment opportunities available to investors- namely, away from large firms and towards smaller, riskier firms. According to Philippon:

After the War, large established firms with high cash flows appear to have the best investment projects. As a result, the demand for financial intermediation is small. Starting in the 1970s, investment opportunities shift away from large profitable firms towards young firms with low current cash flows, and the demand for intermediation increases. These predictions of the model are consistent with the historical evidence on General Purpose Technologies, the role of Electrification in the 1920s and Information Technology starting in the 1970s

His research provides some compelling evidence of this trend. Since WWII, the percentage of financial services provided to corporations with low cash flows (read: higher risk) has grown dramatically. These services are necessarily more complex, requiring more intermediation (read more fees) thus fueling the rise in the financial services industry.

Philipon’s equilibrium model suggests that the finance industry will need to shed roughly 700,000 jobs to bring it back into equilibrium. Concordantly, the degree of intermediation and complexity will decrease, and investment opportunities in larger, higher cash flow firms will be relatively more attractive.