In 2006 (long before the crisis started), I was working on a project to understand the evolution of the U.S. financial industry. I concluded that its growth seemed to reflect fundamental economic needs up to 2001, but that it was not clear (at least to me) why it kept growing so quickly after 2002.
Based on my simple model, I thought the financial sector was about one percentage point of GDP too large (on the virtues on simple models, see Krugman). In April 2008, in an interview with Justin Lahart of the WSJ, my idea was translated in the following way: "Mr. Philippon argues that the surge of financial activity that began in 2002 created an employment bubble that is now bursting. His model suggests total employment in finance and insurance has to fall to 6.3 million to get back to historical norms, and that means losing an additional 700,000 jobs in the sector." In truth, my model is not about the number of jobs but about the GDP share, so it would be more accurate to say that the annual wage bill of the financial sector needs to shrink by approximately $100 billion.
At the time, this sounded like an overly pessimistic - even unrealistic - prediction. Not anymore. These days the market seems to expect the financial sector to shrink to zero. This, however, will not happen. Having been a bear two years ago on the financial sector, I don't feel obliged to inflate my pessimism credentials now by ringing a death knell for this industry. Rather, I hope that I am in a good position to give a more or less objective assessment of the situation.
But first, a little bit of history.Financial institutions provide services to households and corporations. The financial sector's share of aggregate income reveals the value that the rest of the economy attaches to these services. Historical data from the United States shows surprisingly large variations in the economic importance of the financial industry.
The figure above shows the GDP share of all finance (commercial banking, investment banking, private equity, etc.) and insurance (life and property) services in the U.S. from 1860 to 2007.
The financial industry was around 1.5% of GDP in the mid-19th century. The first large increase between 1880 to 1900 corresponds to the financing of railroads and early heavy industries.
The second big increase between 1918 and 1933 corresponds to the financing of the Electricity revolution, as well as automobile and pharmaceutical companies. GE did its IPO in 1913, GM in 1920 and Procter&Gamble in 1932. Key discoveries of the 1920s and 1930s, such as insulin and penicillin, became mass-manufactured and distributed.
After a continuous collapse in the 1930s and 40s, the GDP share of finance and insurance industries was down to only 2.5% of GDP in 1947. It recovered slowly and was mostly stable at around 4% until the late 1970s, and then grew quickly to reach 8.3% of GDP in 2006.
The third large increase, from 1980 to 2001, corresponds to the financing of the IT revolution. 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.
The real economy and the future of the financial industry
The interactions between the financial industry and the rest of the economy are complex. Economic growth in the 1960s was outstanding, but seemed to require little financial intermediation. Finance grew quickly in the 1980s while the economy stagnated, and the pattern changed again in the 1990s.
So it is certainly not true that a large financial sector is required for sustained economic growth (see the 1960s). Rather, 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. Moreover, the U.S. financial sector will keep providing services to consumers and innovative firms in other countries.
What the current financial crisis tells us is that we might not need to spend more than 8% of our economic ressources to buy these financial services. 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 is still about $1 trillion a year. That is still about $1 trillion a year. But what, then, is to become of the rest of the financial engineers? They could always go back to being...engineers.