Has Expansion Of Finance Been Good For The Economy?

The financial services industry has doubled its share of GDP since 1950. This article asks whether the value added by the financial industry has contributed to the growth of the economy. We know that it has benefited the financial services industry, however. Its share of corporate profits has grown from 10% in 1950, to as high as 40% prior to the financial crisis. In other words, profits have grown twice as fast as its share of value added to the economy.

The financial sector's purported mission is to allocate scarce resources to their most productive use. It appears that it has expanded its share of national income without allocating resources to their most productive use. We had a stock market bubble in the 1990's in which Wall Street funneled billions of dollars into technology firms that failed not long after they were brought public. Early investors made fortunes by purchasing IPO shares and selling them to less privileged investors after the share prices had doubled or tripled. Wall Street then found a way to turn sub-prime mortgages into AAA securities by the use of mathematical magic and the help of rating agencies. These securities were sold to "sophisticated" investors. Some used them as collateral to borrow money in wholesale markets at low interest rates. This method of liquidity provision turned hedge funds into unregulated banks.

In theory, the financial sector might also contribute to corporate governance. Wall Street can hold corporate CEO's accountable for performance by holding managers accountable for increasing the value of stocks. It is questionable as to whether this has improved corporate governance. It is certainly clear, however, that it has given Wall Street more influence over the internal operations of corporations. Corporation managers set expectations for meeting quarterly objectives and they are held accountable for meeting those objectives. The most valued CEO's are those that are best at playing that game. It may not be the game that is best for long term shareholders.