Implications of Financialization

In this post I’m going to reflect a little on the impact that financialization has had on our economy and speculate on the implications of that for recovery plans being put into place by the federal government. For the purposes of this post by “financialization” I mean the increased role of the financial sector in our total economy. There’s a relevant article on the subject here.

The graph above illustrates the role that the financial sector has played in our national economy from 1860 to, roughly, the present. It was produced by economist and professor of finance Thomas Phillippon, from whom a substantial amount of the information in this post was, er, borrowed.

As you can see there have been peaks and valleys. Dr. Phillippon’s interpretation of the periods of sharply rising slopes is that they correspond to several industrial revolutions: the financing of railways and heavy industry from 1880 to 1900, the financing of electrification and the automobile industry that took place between 1918 and 1933, and the financing of the personal computer/Internet revolution that began in the early 1980’s and continued until 2001. Here’s what he says about the period since, a period that’s seen a sharp increase in the role of the financial sector in our economy in our history:

From 2002 to 2006, I am not quite sure what the financiers were doing. Or rather, I am not sure that the services provided by insane trading volumes and real estate derivatives were worth the price tag.

I have some quibbles with Dr. Phillippon’s interepretation of the sharp rises. With respect to the industrial revolution that I know best, the financing of technology firms between 1980 and 2001, I don’t believe that most of that increase was caused by financing startups as Dr. Phillippon suggests:

…it appears that a large financial sector is needed when economic growth is driven by young, cash-poor, innovative firms. This brings us to our last topic.

The future of the financial industry depends on the needs of the real economy. The U.S. is still an amazingly innovative economy. New startups still need sophisticated financial tools, such as venture capital and risky loans. IPOs will come back. Sophisticated equity traders will be needed to price these new stocks. Restructuring, M&As and efficient tools for managing credit risk will still be needed as young sprouts grow and challenge tall old corporate trees.

Certainly that’s something we should be able to measure. Is most of the borrowing and utilization of complex financial instruments being done by startup companies? Or, as I believe, is it something that’s largely fueled by the established companies in their responses to the upstarts?

Whatever the reasons for the increases in the role of the financial sector in our national economy, there’s little doubt that it’s happened and, judging by the fallout among financial services companies, that we are substantially over-invested in financial services companies. Here are Dr. Phillippon’s observations on that subject:

My own estimate is that the financial sector should be around 7% of GDP if the U.S. remains an innovative, relatively finance-intensive economy.

That’s a drop of nearly 13%. In another post he notes:

Has financial creativity been over compensated? We construct a benchmark series for the relative wage in finance, controlling for education and employment risk as well as time varying returns to education. Our benchmark wage accounts well for the observed relative wage between 1910 and 1920, and from 1950 to 1990. From the mid-1920s to the mid-1930s, and from the mid-1990s to 2006, however, the compensation of employees in the financial industry appears to be too high to be consistent with a sustainable labor market equilibrium.

Overall, we conclude that bankers were paid about 40% too much in 2006.

Despite the collapse of the sector total compensation in the financial services sector of the economy fell remarkably little in 2008. They’ve got a long way to go and propping that up is counter-productive.

Over-investing in any sector of the economy has implications. For one thing it means that we’re under-investing on other sectors. I believe that we’re over-invested in the financial sector, in construction, in health care, in education, and, probably, in government. What sectors have we been under-investing in? We’re graduating fewer science and engineering students as a proportion of our population now than we did in 1993 (the number of S&E graduates have increased 8% over the period while the population has increased 13%).