The key question is not whether finance has productive uses–of course it does–but whether the US and other high-income economies are devoting more resources to finance than can be justified by the gain in social welfare from these activities. Back in 1984, James Tobin thought the answer might be “yes.” A transcript of lecture, “On the Efficiency of the Financial System,” was published in July 1984 issue of the Lloyds Bank Review. Tobin wrote:

Just the other day, the New York Times listed forty-six business executives whose 1983 compensation (salary and bonus, exclusive of realizations of previously acquired stock options) exceeded one million dollars. What struck me was that sixteen members of this elite were officers of financial companies.’ No wonder, then, that finance is the favourite destination of the undergraduates I teach at Yale, and that 40 per cent of 1983 graduates of our School of Organization and Management took jobs in finance. … All university educators know that finance is engaging a large and growing proportion of the most able young men and women in the country.

Tobin immediately acknowledges the social functions of finance: facilitating transactions, allowing the pool of savings in an economy to be channeled to productive investment in physical and human capital, pooling risk through insurance and hedging, providing incentives for provision of information and analysis that is part of the checks and balances for corporate management and also provides valuations and guidance for existing firms and entrepreneurs. But as Tobin points out, the financial system accomplishes a number of these goals in only a partial way, and in some cases–a recent example would be the Great Recession of 2007-09–breakdowns in the financial system contribute to an overall economic crisis.

I want to point out that the services of the [financial] system do not come cheap. An immense volume of activity takes place, and considerable resources are devoted to it. Let me remind you of some of the relevant magnitudes. Item: The Department of Commerce categories Finance and Insurance generate 4 1/2-5 per cent gnp, account for 5 1/2 per cent of employee compensation, and occupy about 5 per cent of the employed labour force. They account for 7 1/2 per cent of after-tax corporate profits. About 3 per cent of personal consumption, as measured by the Commerce Department, are financial services. These figures do not include the legal profession. It amounts to about 1 per cent of the economy, and a significant fraction of its business is financial in nature.

Is it worth it? Tobin admits that he can offer only suspicions, not a proven case.

Any appraisal of the efficiency of our financial system must reach an equivocal and uncertain verdict. In many respects, as 1 have tried to indicate, the system serves us as individuals and as a society very well indeed. As I have also tried to say, however, it does not merit complacency and self-congratulation either in the industry itself or in the academic professions of economics and finance. …

I confess to an uneasy Physiocratic suspicion, perhaps unbecoming in an academic, that we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity. I suspect that the immense power of the computer is being harnessed to this `paper economy’, not to do the same transactions more economically but to balloon the quantity and variety of financial exchanges. For this reason perhaps, high technology has so far yielded disappointing results in economy-wide productivity. I fear that, as Keynes saw even in his day, the advantages of the liquidity and negotiability of financial instruments come at the cost of facilitating nth-degree speculation which is short-sighted and inefficient.

Many of Tobin’s concerns from 40 years ago have a very modern flavor. In recent years, about one-third of all Harvard and Yale undergraduates (not just those in the School of Management, as in Tobin’s speech) take jobs in finance or consulting after graduation. The Finance, Insurance, and Real Estate sector is now about 7-8% of GDP, substantially higher than 40 years ago.

Perhaps most troubling, it seems as if finance should be a classic economies-of-scale industry. Imagine that I have $10,000 invested in a mutual fund, and then I raise that amount to $20,000. Sure, it costs the managers of the fund something to set up my account, and to inform me about it. But it seems unlikely that the costs of managing $20,000 are twice as much as managing $10,000–or that the costs of managing $100,000 are ten times as much as the costs of managing $100,000. However, the income received by the financial sector has tended to track the total quantity of resources received over time–that is, an industry that seems as if it should be displaying economies of scale does not seem to be doing so (for discussion, see here).

I have no more proof of the inefficiencies of the financial sector than did Tobin, 40 years ago. Indeed, the fact that the same complaints were being made 40 years ago perhaps suggests that the complaints themselves are both real, given the imperfections of any real-world set of markets, and also overblown.

But perhaps being a party who is at the table when financial transactions are made just gives the financial sector a chance to cut off a slice of the pie in every deal. After all, when you are buying tickets to a show or taking out a mortgage or the credit card company is charging the store for your transaction, you don’t have a realistic option in the moment to be shopping around. If a company is issuing bonds, dealing with a private equity, repurchasing stock, or hedging exchange rate risk, it has a limited number of financial parties with whom it will want to deal, and putting out such financial deals to the lowest bidder doesn’t seem realistic. Thinking about who sits in the middle of transactions–what mixture of rules and competition caused them to be there, and what they do to deserve their seat at the transaction–seems worth some thought.

For a variety of modern takes on the question of whether finance is worth it, see the “Symposium on the Growth of the Financial Sector” in the Spring 2013 issue of the Journal of Economic Perspectives (where I work, then and now, as Managing Editor):

Published by conversableeconomist