Why Finance has Taken Over the American Economy

One of the puzzles of the American economy over the past generation has been the rise of the financial services industry, which grew from less then 5 percent of the economy in 1950 to more than 8 percent in 2008, Even more impressive is finance's share of corporate profits, which has at times topped 45 percent. In this little column Noah Smith gives a very clear answer to the first half of that question, why finance has grown.

First, why did finance grow so much as a percent of output since 1980? And second, how did it keep being so profitable even as its size ballooned?

Let’s start with the question of why finance has grown so much in recent years. We can get some clues to this by considering which parts of finance have grown. Financial economists Robin Greenwood and David Scharfstein took a look at this back in 2013, and found that the acceleration since 1980 has come from two sources: 1) asset-management fees, and 2) lending to households.

Asset-management fees are middleman costs that all kinds of players in the finance industry charge to move money around. These fees are usually charged as percentages of the assets being managed. The amount of wealth in the U.S. economy has soared since 1980 -- just think of the rises in the housing and stock markets over that time -- meaning that the middlemen in the finance industry have been taking their percentage fees out of a much larger pool of assets. That has increased finance’s share of national income. People also started to put more of their money in asset markets -- where money managers charge percentage fees -- instead of keeping it in banks or government bonds, which don’t.

That certainly makes sense. And then:

The other big piece of finance’s growth has been household credit, with a lot of it going for big ticket items like houses and cars, U.S. households have been borrowing more and more since 1980 -- as Greenwood and Scharfstein report, household credit soared from 48 percent of GDP in 1980 to 99 percent in 2007. Mortgages were by far the biggest piece of this. When people borrow more, the finance industry makes money by collecting interest, and also by charging middleman fees on lending transactions.

I confess that this connection never occurred to me, but it now seems pretty obvious. Why are banks bigger? Because Americans borrow more money. Why are banks a bigger share of the economy? Because as we borrow more money we end up paying more of our incomes in interest on loans and less to buy stuff.

The question of why banking is so profitable remains obscure, although Smith has some suggestions. But I remain awed that the question of why the financial sector has gotten so big has such a clear and simple answer.