While few would argue that the financial crisis has not brought the real economy down with it, there is considerably less clarity about what the positive contribution of the financial sector is during normal times. This lead commentary in the current Vox debate on the issue focuses on the value-added of risk and government subsidies in national accounting, and makes an important distinction between risk-taking and risk management.
There is no doubting the financial sector has a significant impact on the real economy. Financial crisis experience makes this only too clear.[1]Â Financial recessions are both deeper and longer-lasting than normal recessions. At this stage of a normal recession, output would be about 5% above its pre-crisis level. Today, in the UK, it remains about 3.5% below. So this much is clear: Starved of the services of the financial sector, the real economy cannot recuperate quickly.
But that does not answer the question of what positive contribution finance makes in normal, non-recessionary states. This is an altogether murkier picture. Even in concept, there is little clarity about the services that banks provide to customers, much less whether statisticians are correctly measuring those services.[1]Â As currently measured, however, it seems likely that the value of financial intermediation services is significantly overstated in the national accounts, for reasons we now explain.
‘Excess’ Returns in the Banking Sector
The headline[1] national accounts numbers point to a significant contribution of the financial sector to the economy. For the US, the value-added of financial intermediaries was about $1.2 trillion in 2010 – equivalent to 8% of total GDP. In the UK, the value-added of finance was around 10% of GDP in 2009. The trends over time are even more striking. For example, they suggest that the contribution of the financial sector to GDP in the US has increased almost fourfold since the Second World War.
At face value, these trends would be consistent with large productivity gains in finance. Pre-crisis, that is what the bald numbers implied. Measured total factor productivity growth in the financial sector exceeded that in the rest of the economy (Figure 1). Financial innovation was said to have allowed the banking system to better manage risk and allocate capital. These efficiency gains in turn allowed the factors of banking production (labour and capital) to reap the benefits through high returns (wages and dividends).
Figure 1: Differential in TFP growth between financial intermediation and the whole economy[a,b]
Source: EU KLEMS and authors’ calculations. The EU KLEMS data are available online at EU KLEMS Growth and Productivity Accounts. For further detail on the database, see O’Mahony, M and Timmer, P M (2009), “Output, input and productivity measures at the industry level: the EU KLEMS Database”, Economic Journal, 119(538), pp. 374-403.
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Notes: [a]TFP estimates beased on the value-added approach and account for changes in both the quantity and quality of labour. [b]A positive number implies higher TFP growth in financial intermedation relative to the whole economy.
