How much value does the finance industry create? That is the question asked by John Cochrane in this recent draft essay (non-PDF version here), in response to a recent Journal of Economic Perspectives article by Robin Greenwood and David Scharfstein.
Both should be required reading for any introductory finance class. There is so much in these essays that one blog post couldn't hope to adequately cover the topic, so don't expect this to be anything resembling a complete response. Everyone knows that the finance industry has grown in America. In 1980, finance took home about 5% of all the income in America; in 2007, about 8%. This has led many people to question whether all this activity is worth what we pay for it; in other words, how much of the increase in finance-industry GDP is actually value added, and how much is "rent" extracted from the rest of the economy? Cochrane makes the excellent point that the question of "How much value does industry X really create? " This list applies to almost any policy question in all of economics. The Grumpy Economist: Is Finance Too Big? Is finance too big?
Here's a draft essay on the subject. There is a pdf on my webpage, and updates, revisions and a final version will end up there. This came about as a "response essay" to Robin Greenwood and David Scharfstein's "The growth of modern finance" for the Journal of Economic Perspectives. That's why Robin and David are the target of a lot of criticism. But they're really just standing in for a lot of opinion that finance is "too big," in part because they did such a good and evenhanded job of synthesizing that point of view.
I'm sure the JEP will make me cut it down and tone it down, so this is the fun first draft. Is Finance Too Big? John H. I. The US spends $150 billion a year on advertising and marketing[3]. $150 billion, just to trick people into buying stuff they don’t need. There are 2.2 people doing medical billing for every doctor that actually sees patients, costing $360 billion[4] -- 2.4% of GDP. A while ago, my wife asked me to look at light fixtures. II. A. B. Getting Economics to Acknowledge Rentier Finance. The economics discipline has for the most part managed to ignore the 800 pound gorilla in the room: that of the role that the financial services industry has come to play.
Astonishingly, even though the reengineering of the world economy along the lines preferred by mainstream economists resulted in a prosperity-wrecking global financial crisis and a soft coup by financiers, the discipline carries on methodologically as if nothing much had happened. And one of its huge blind spots is its refusal to acknowledge the role of banking and finance in modern commerce. Interest rates are simply an input into the preferred form of macro models, DSGE (dynamic stochastic equilibrium models).
Economies are assumed to be self correcting, and to automagically “correct” to full employment. All shocks to the system are exogenous. Rentiers are those who benefit from control over assets that the economy needs to function, and who, therefore, grow disproportionately rich as the economy develops.