economics

Has the financial sector become a drag on the real economy?

American Compass
Oaktree Capital
Genesis
Response
Penultimate
Finale

Oren Cass

American Compass

April 28th, 2021
An effective financial sector is vital to a well-functioning market economy, but in America the sector has metastasized. Its share of corporate value added has risen from 4% after WWII to 6% in the 1960s to 9% in the 1980s to a record 14% last year. Its share of corporate profits, once less than 10%, reached 40% in the early 2000s and has remained consistently above 25% since.
Top business talent has followed. In 2020, 34% of graduates from Harvard’s MBA program entered finance, as did 34% from Stanford's. At both schools it was the most popular industry and offered the most generous compensation packages.
In theory, Americans might just love themselves some great financial services. A finance-dominated economy might deliver extraordinary value to consumers and businesses, drive investment and innovation, and shift upward the nation’s economic trajectory. In practice, this is obviously not the case. The “value added” that economists record as financial firms generate trading profits and rack up fees does not “add value” to the real economy in any meaningful sense. It does not improve the typical family’s life, create better jobs, or expand productive capacity.
The clearest evidence for this disconnect comes from data on investment. The core task of financial markets should be to make capital readily available to businesses that might put it to productive use. Yet as the sector has exploded in scale, the cost of capital hasn’t fallen. Instead, businesses have adopted a strong preference for returning their capital back to the financial markets instead of re-investing it, and net business investment has steadily declined as a share of gross domestic product (GDP). In research published last month, American Compass showed that the net outflow of capital from public companies has more than doubled as a share of GDP over the past four decades, and about half of market capitalization now sits in firms who make such large shareholder payouts that they do not invest enough to replenish their depreciating capital stock.
Rather than channel capital toward productive investments, financial markets today appear largely to facilitate the speculative and circular trading of assets. Firms bet against each other, generating fees for all involved at each step. Hedge funds have tried to justify their catastrophic underperformance by explaining that they savvily hedge against downturns but, when the Covid crash struck, this proved simply untrue. Private equity firms used to generate massive returns buying low and selling high, but those bargains are long gone and now the firms bid against and sell mostly to each other or, increasingly, themselves. It has been years since they outperformed simple index funds, though they do manage to bankrupt the companies they buy at about ten times the economy’s typical rate.
Sophisticated financial analysts love to discuss opportunity cost and diminishing returns, until it is their activity proving costly and their returns diminishing. Our nation would be more prosperous with a smaller financial sector that left more talent and capital to the real economy.
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