Monday, August 10, 2015

The Financial Sector And The US Economy

There is an obvious relationship between the size of an economy and the need for financial services.  The financial sector in the US has tended to grow with the size of the economy.  In the late 19th century it was about equal to GDP.  It grew to 3 times GDP prior to the Great Depression and its share dropped by 50% after the Great Depression.  It was about 4 times GDP by 2000.  There is a strange relationship, however, between the size of the financial sector and financial services income.  There are no economies of scale in the financial sector.  Financial services income is a fixed proportion of total intermediate assets issued by firms in the financial sector.  For example, the income received by a bank for providing a $100,000 mortgage is twice the income that it receives for providing a $50,000 mortgage.  The cost of providing the larger mortgage is no greater than the cost of providing the smaller mortgage, but the banks income doubles by providing the larger mortgage at the same cost.  Similarly, the cost of managing a $50,000 portfolio by an financial firm is about the same as the cost of managing a $100,000 portfolio.  However, the income received for managing the larger portfolio is twice what the firm receives for managing the smaller portfolio. 

The graph below shows the historical relationship between the size of the US economy and two ways of measuring the size of the financial sector.  The orange line shows the market value of all assets provided by the financial sector.  The green line shows the income received by the financial sector for the services provided.  The income is a measure of the value added by the industry.  It is calculated by subtracting the total cost of purchased equipment and services from total revenue.  Most of the value added consists of wages paid by firms along with profits. Since income grows faster than costs, industry profits will grow faster than the economy.

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