Once you’ve stated the obvious point that the financial sector “has grown to an unprecedented share of the economy,” how do you make sense of that growth?

Well, if you’re Paul Krugman, you send us to Thomas Philippon’s unpublished essay, “Has the U.S. Finance Industry Become Less Efficient? On the Theory and Measurement of Financial Intermediation” (pdf) [ht: br]. And that’s when the fun—or the horror—begins.

Here we have neoclassical economics in all its glory, starting with the following proposition:

Since the opportunity cost of being a banker is the wage in the non-financial sector, and since this wage is proportional to aggregate productivity, the income share of finance remains constant on the balanced growth path.

An extraordinary syllogism, based on two absurd premises—that the “wage” of a banker bears any resemblance to wages in the nonfinancial sector (has he bothered to even look at the levels of compensation in the financial sector?), and that that “wage” is proportional to aggregate productivity (thereby presuming the neoclassical illusion that finance is productive of something, which is appropriately compensated). The conclusion (that “the income share of finance remains constant on the balanced growth path”) is simply laughable except—wait for it: “I test this hypothesis and find that it holds well.”

In the rest of the paper, Philippon marshals all of the neoclassical machinery—of production-function econometrics, given preferences, utility-maximizing households, monitoring technology, equilibrium, and so on—to analyze the “production of intermediation services” in order to arrive at “the main conclusion of the paper.” To wit,

In other words, what Philippon finds is that the cost of financial intermediation, defined as income divided by output, (a) is “remarkably stable” over 130 years and (b) “has been trending upward, especially since the late 1970s,” notwithstanding the development and use of new information technologies.

Unbelievable! All that neoclassical machination to “prove” that, during more than a century, it took only two cents of “cost” to produce a dollar’s worth of financial “output” and that the cost of financial intermediation has risen in the last few decades, to 3 cents.

And that forms the basis for Philippon’s final question:

How is it possible for today’s finance industry not to be significantly more efficient that [sic] the finance industry of John Pierpont Morgan?

Boy, those banks were so efficient for so long (like in the good old days of the House of Morgan), and now they’re not (today, with Jamie Dimon’s JPMorgan Chase). And we have no idea why that’s the case.

Perhaps, Philippon suggests, it’s because there’s been an increase in trading activity and people trade so much because—wait again—”they simply enjoy it.”

Garbage in, garbage out. But think about it: if we throw a lot more research money at the economists at the Stern School of Business at New York University and the National Bureau of Economic Research, and hold more research seminars on the topic at Stanford, Yale, NYU, Harvard, and the Paris School of Economics, maybe someday we’ll find out why it is that “the non-financial sector [is] still transferring so much income to the financial sector”


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