Why Finance Gets Big. And Why It's Not a Problem

The growth of the financial sector relative to the rest of the economy is becoming more and more central to the public debate. Common wisdom posits out that the "financialization" of the economic system generates increasing wealth inequality and therefore represents a serious problem with the market economy. Without denying the existence of rent-seeking, trustworthiness, reliability, and more general agency problems, an increasingly important financial sector does not necessarily represent 'per se' a problem for the economy. In fact, as one of the functions of finance is to preserve existing wealth, and wealth has grown over time relative to labor income, it seems natural that the financial sector should grow even in mature economies. This is likely the most striking result of Finance and the Preservation of Wealth, an article by Nicola Gennaioli (Department of Finance), Andrei Shleifer (Harvard University), and Robert Vishny (University of Chicago) published in the The Quarterly Journal of Economics (2014), Volume 129 (3), doi:10.1093/qje/qju012).

Recent empirical evidence shows that the weight of the financial sector relative to gross domestic product (GDP) has sensibly increased since World War II, and especially over the last thirty years and for most of the developed countries. Much of this rise of finance, at least in the US, comes from the increasing presence of financial intermediaries, such as asset management firms and intermediaries for mortgage and consumer loans. Without such players, savers would unlikely have access to complex products such as mortgage-related products. Interestingly, despite the increasing size of the financial sector as a whole, overall fees on private equity and hedge funds have stayed constant, unlike management fees on mutual funds.

In this paper, the authors argue that the key component that explains the increasing size of the financial sector is the preservation of wealth of investors. Financial intermediaries enable investors not only to keep their savings, but also to have access to investments that potentially make their wealth increase over time, on average. As wealth has increased over time relative to income, this explains the consistent growth of the wealth to GDP ratio over the last decades. Also, according to the authors, a by-product of the increasing size of the financial sector is the reduction of fees. This implies that investors allocate increasing shares of their wealth to intermediate financial products, shifting over time to riskier, and hence more expensive, financial products. This finally leads to increases in unit costs, although the average fees for given products decline.

These results point decisively to the role of financial intermediaries as useful institutions that helps investors, on average, to retain their savings. As such, the finance sector should naturally grow in mature economies, although we cannot deny the existence of relevant agency problems.