THE UTOPIA OF FINANCE FOR ALL

In the last thirty years, dramatic changes in financial systems around the world amounting, de facto, to a revolution have brought many ... advances. We have come closer to the utopia of finance for all.

— Raghuram Rajan and Luigi Zingales, Saving Capitalism from the Capitalists

Finance looms far larger in both advanced and emerging economies than it did 30 or 40 years ago. Few readers will need convincing of that fact. Newspapers and television programs report regularly on the huge size of global capital markets and trading activity. Financial centers such as New York, London, or Hong Kong have ballooned in importance. Huge bonuses paid to bank trading staff and management are highly contentious in many countries, but the money earned by hedge fund managers dwarfs that of mere bankers. Finance has become the destination of choice for top graduates from elite universities and business schools throughout the world. Some commentators talk about the "financialization" of our economies. It is an ugly word, but it seems to capture the reality: more finance, better paid, playing a more pervasive role in economic life.

Impressions often deceive. But in this case, sober analysis confirms what anecdote suggests. Significantly in most advanced economies but dramatically in the United States and the United Kingdom, finance has accounted for a growing share of national income. And across the world, in many different financial markets, trading activity has massively increased, its growth far outpacing that of real economic activity.

Finance has grown more rapidly than the real economy since modern capitalism first developed in the nineteenth century. Analysis by Andrew Haldane shows finance in the United Kingdom growing on average by 4.4% per year from 1856 to 2008, while the economy grew at 2.1%.

But Haldane's analysis also reveals big variations in growth over time. From 1856 to 1914, the value-added of UK financial services grew 3.5 times more rapidly than national income. The economy became more complex as industry grew at the expense of agriculture; companies issued bonds and stocks on public markets; individuals began to accumulate savings; and London became a financial center servicing global capital flows. As a result the financial industry became far more important.

From 1914 to 1970 finance grew less rapidly than total GDP, even though the economy, despite two world wars, grew faster than in the previous period: by 1970 finance accounted for a smaller share of a far bigger economy than in 1914. But from 1970 on, and in particular after 1980, the picture changed again. From 1970 to 2008 UK finance grew twice as fast as UK national income, with the outperformance becoming greater as each decade progressed.

The U.S. experience, illustrated in Figure 1.1, was similar. Between 1850 and the crash of 1929, finance's share of national income grew from 2% to 6%, with a particularly strong increase throughout the 1920s. That share collapsed in the 1930s and even in 1970 stood at a significantly lower 4%. From 1970 to 2008 it more than doubled. In 2007 finance played a bigger role in advanced economies, as measured by share of GDP, than ever before.

The growth of finance from the 1970s on, and the acceleration of that growth over the subsequent decades, would be an important issue for economic research even if we had not suffered the financial crisis of 2007–2008. Finance, after all, is not a consumer product or service, valued in itself, like a car or a restaurant meal or clothing. No one gets up in the morning and says "I feel like enjoying some financial services today." Finance is a necessary function to enable the production of the goods and services we actually enjoy. And it makes up a large enough proportion of the economy that the cost efficiency with which the financial industry performs these functions has a significant impact on people's living standard. Even if there had been no crisis, it would be worth asking whether we are getting value for money.

But it is the financial crisis of 2007–2008 that makes it not merely interesting but vital to ask searching questions about the economic impact of this huge increase in financial intensity. For the crisis and its aftermath have been an economic catastrophe, a setback to the success of the market economy system only previously matched by the two world wars and the Great Depression of the 1930s.

We cannot therefore avoid the questions: Which aspects of this growing financial intensity were beneficial and which harmful? Which led to the crisis, and how radically must we now reform to prevent a repeat?

Increasing Real Economy Borrowing ... and Saving

The first step is to identify which specific financial activities contributed most to finance's remarkable growth. Research by Robin Greenwood and David Scharfstein shows that two factors dominated.

First, finance made much more money out of providing credit to the economy, and in particular credit to households. Second, asset management activities and profits grew dramatically; that growth reflected increased fees flowing to a wide range of financial institutions such as securities firms, mutual funds, hedge funds, and venture capitalists. But it also entailed the extensive trading, market-making, and funding activities that form inputs to the asset management process.

Other aspects of finance also grew, but less dramatically. Insurance for instance grew slowly as a percentage of GDP but without the sharp acceleration in growth that marked debt and asset management–related activities.

Greenwood and Scharfstein's findings reflect a startling and important fact — that the role of debt in the U.S. economy, and in most other advanced economies, grew dramatically. Finance made lots more money from providing credit, because households and companies borrowed much more. In 1945 total private...