The inefficient financial sector

May 4, 2009

Jim Surowiecki thinks that the rise in the size of the financial sector — at least until this decade — makes perfect sense:

The desire to bring back the boring, small banking industry of the nineteen-fifties is understandable. Unfortunately, the only way to do that would be to bring back the economy of the fifties, too. Banking was boring then because the economy was boring. The financial sector’s most important job is channelling money from investors to businesses that need capital for worthwhile investment. But in the postwar era there wasn’t much need for this…

The corporate world was transformed by revolutionary developments in information technology and by the emergence of new industries like cable television, wireless, and biotechnology. This meant that the economy became, and has remained, far more competitive, while corporate performance became far more volatile. In the nineteen-eighties, companies moved in and out of the Fortune 500 twice as fast as they had in the fifties and sixties. Suddenly, there were lots of new companies with big appetites for outside capital, which they needed in order to keep growing. And it was Wall Street that helped them get it… Thomas Philippon, an economist at N.Y.U., has shown that most of the increase in the size of the financial sector in this period can be accounted for by companies’ need for new capital.

I’m sure it’s true that the economy’s capital-raising needs grew sharply between the 1950s and the 1990s. But why does that mean that the financial sector should have grown commensurately? After all, there was just as much “innovation” going on in finance as there was elsewhere; the technology revolution was in many ways driven by the needs of the financial sector. Wouldn’t you expect, in that case, that financial companies would have become more efficient at intermediating between companies and investors? Shouldn’t it have been much easier and much cheaper to issue a billion-dollar bond in 1998 than it was in 1968?

Famously there was something quite cartel-like during the dot-com boom, when the big investment banks all managed to continue to charge an eye-watering 7% underwriting fee for IPOs despite the fact that most of the companies pretty much sold themselves, and similarly-sized bond issues were coming to market at the same time for underwriting fees of about 0.1% or less. And when the likes of Bill Hambrecht tried to break the big banks’ iron grip on the market, they generally failed pretty miserably.

Even so, one would hope and expect that between sell-side productivity gains and a rise in the sophistication of the buy side, any increase in America’s financing needs would be met without any rise in the percentage of the economy taken up by the financial sector. That it wasn’t is an indication, on its face, that the financial sector in aggregate signally failed to improve at doing its job over the post-war decades — a failure which was then underlined by the excesses of the current decade and the subsequent global economic meltdown.

On this view, the seven-, eight-, and nine-figure salaries pulled down by Wall Street folks aren’t a sign of how efficient they are at doing their jobs, but are rather a sign of how inefficient their companies are. As Ryan Avent says:

When you have a few people taking home billions, that’s a sign of either very good luck or some brilliant new strategy. When you have a lot of people in finance taking home billions, then something has gone badly wrong. Either something unsustainable is building, or there are some serious inefficiencies in the market.


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