The graph above shows that the financial industry now makes roughly half of all nonfarm corporate profits in the U.S., a share which has risen five-fold since the end of World War II.
Other things to note from this graph: (1) there is clearly a secular component to the rise; (2) the variance around the secular trend seems somewhat cyclical, but not enormously so; and (3) the financial sector's share of total profits has continued to increase through the recession and financial crisis.
Part of this is the expansion of the financial sector within the American economy. Employment in the broadly-defined financial industry has risen from roughly 4 percent of payroll employment to 6 percent.
But most of it is a huge increase in the profit per man-hour worked in the financial industry. Making some rough approximations about the financial industry's share of payroll employment, I can estimate that the average hour worked in the financial industry generates nearly 30 times the average per-man-hour profit in the rest of the economy. That's up from six times the average in 1964.
This could very well be a question of global comparative advantage, but I find that hard to believe on the basis of the employment figures. It seems substantially more likely, rather, that the financial sector's profitability comes from the implicit and explicit subsidies of a market with high barriers to entry.
Let's run though the explicit subsidies: the mortgage-interest deduction and other homebuyer credits, student loan aid, federal guarantees on debt, the preferential tax rates on capital gains and dividends, interest on reserves at the Fed, and the FDIC guarantee. The financial industry also benefits from substantial implicit regulatory subsidies such as "too-big-too-fail."
I worry that our response to the financial crisis and the recession -- providing a "backstop" for the financial industry -- has amounted to little more than an increase in both forms of subsidy. That doesn't do very much for financial stability.
What's really amazing is how finance accounts for less than 10% of overall value added yet pulls in over 50% of the profit.
ReplyDeleteI reach the same conclusion, i.e. this is explained not by comparative advantage but huge subsidies by man hour.
I would be careful with equating employment with value-added. It is likely that financial-sector workers would still be, without the subsidy, more productive than the average worker on the basis of higher educational attainment and human capital. But obviously we agree that the profits seem completely out of line with any model of a competitive economy without barriers to entry or industry subsidies.
DeleteRight, I'm not equating the two. But profit in finance seems to be far more out-of-wack viz. value added than any other sector. I'm not doubting that financiers are more productive, but this much? Hard to believe.
DeleteI don't think it has to do with educational achievement, but more with revenue per employee. Also, the fact that finance tends to be a transaction-based business means the more deals you execute, the more "productive" you are.
DeleteThis is an interesting line of research and already reaching some provocative conclusions. I'm entirely supportive, but I had a question.
ReplyDeleteMany companies which have overseas markets or subsidiaries might be collecting significant profits not reported in some US figures. Still, those revenues might be very significant to US investors and the market value of the firm overall. Of course, the large financial firms also have offshore branches, but there is an important anchor keeping many transactions in the US markets.
I'm raising this issue only to strengthen the ultimate argument, not to undercut the work.
On the issue of value-added, I think there may be a level of analysis which makes the problem stand out more clearly. Some financial firms make their money by arbitrage rather than by managing wealth, or directly investing in other firms, etc. These arbitrageurs may well add to the liquidity of the markets they use, but clearly their profits add to the costs of other market participants. There are many styles of speculation which might have similar effects.
It would be interesting to estimate the relative size of speculative cash extraction vs. plain financial service.
It's like economies of scale. The bigger the bet.. the bigger the potential win. (only in this case, you are favoured by the rules in play and there's positive asymmetry of information vs the public investor).
ReplyDeleteAnother question here is if this is real sustainable value-added to the economy (1-to-1 bases I mean).
Remember that the profits do not count the salaries and bonuses handed out to the bankers. Those are regarded as costs of doing business. If you multiply the financial sector workforce with median population wide compensation, subtract that from employee compensation (including bonuses to top managers) and tack that on to profit, you would get a much better idea
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ReplyDeleteEvan,
ReplyDeleteI do think that comparative advantage plays a meaningful role as US based firms have dones particularly well at the high profit/low capital-utilization/low employment hours segments of finance (asset management, M&A corporate finance) that have grown globally over the period shown. I would be much more convinced if someone were to show me global data.
I also think that people discount the genuine financial innovation that has occured over time. For instance, consumer credit has risen roughly 3-fold relative to GDP since 1952 (roughly the same increase as in your chart). Despite the recent controversies about consumer lending of various types and the government support you note, there are two willing parties (at least) to each of those transactions (the lender and the consumer).
You note student loans as one of the subsidized causes, yet here there are three willing participants (the student, the bank and the school) with the financial institution playing a relatively small part. The educational institutions are the big winners. If you plotted their "revenues" relative to GDP or some other relevent denominator, you would see a similar growth path. Here the government used the finance industry to pursue a laudable goal of broadening educational access (and took it too far in my view), the schools extracted most of the benefit (along with professors, adminstrators, etc) but FINANCE gets the blame.
I left a tweet, but to clarify, taking corporate profits after tax and then subtracting nonfinancial corporate business after tax doesn't leave you "the financial sector after tax." They are drawn from different tables.
ReplyDeleteMany who look at this go straight to NIPA BEA table 6.19D, and there you can get "finance and insurance," leaving in or out the Federal Reserve, and putting it right against the domestic profits (or total, including "rest of the world").
It also might be useful to draw out what you mean by "the explicit subsidies" you mention. I'm not sure what thread there connects student loans and FDIC and lender of last resort.
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ReplyDeleteMy own feeling is that if the financial sector is supposed to allocate capital, it should do better as the amount of capital expands.
ReplyDeleteWhat does it look like if you regress the secular trend with measures of capital, or capital per capita, in the US?
Mike is right, you can't calculate the share of financial sector profits this way.
ReplyDeleteLook at this (figure 4) - this is done correctly:
http://www.yardeni.com/Pub/ppphb.pdf
Financial sector corporate profits are about 20% of total corporate profits today, about the same as in 1960.
I realize that that the graph you made is one of those that is almost too good to check :)
One clue that your graph was off should have been that the financial sector has been a disaster for investors this decade. It's not likely that the financial sector has been a disaster for equity investors and also explosively profitable at the same time.
Another note, because of the flexibility in accounting for financial firms (you have to make your best guess about loan losses), it's hard to track actual profitability. A lot of "profits" got reversed in 2008-2009.
Lastly, you can think of most financial institutions as levered bond portfolios. Everything else being equal, reported profitability will rise as interest rates fall, and vice versa. Also, the more capital financial institutions hold, the more accounting profit they show (although economic profitability might actually decline because of the cost of holding capital).
There is very little doubt that unit incomes ar additional variable than they were a generation a gone, however this argument is nuanced. it's not clear, as an example, that rising bankruptcy rates have a lot of to try and do with financial gain instability.
ReplyDeleteThanks:
PPI Claims Made Simple
Truly said, in any type of business financial graph always increases with the increase of business. I too had earned lot of profit in my business.
ReplyDelete--Moises Maionica