The Taper and Its Shadow: Central Bankers Need to Explain the Risks of Further Quantitative Easing
Now Live: Finance and the Welfare of Nations

Discussion of Robin Greenwood and David Scharfstein: The Growth of Modern Finance


Robin Greenwood and David Scharfstein: The Growth of Modern Finance:

The U.S. financial services industry grew from 4.9% of GDP in 1980 to 7.9% of GDP in 2007. A sizeable portion of the growth can be explained by rising asset management fees…. Another important factor was growth in fees associated with an expansion in household credit, particularly fees associated with residential mortgages. This expansion was itself fueled by the development of non-bank credit intermediation (or “shadow banking”). We offer a preliminary assessment of whether the growth of active asset management, household credit, and shadow banking--the main areas of growth in the financial sector--has been socially beneficial….


A large part of the growth of finance is in asset management, which has brought many benefits including, most notably, increased diversification and household participation in the stock market. This has likely lowered required rates of return on risky securities, increased valuations, and lowered the cost of capital to corporations. The biggest beneficiaries were likely young firm, which stand to gain the most when discount rates fall. On the other hand, the enormous growth of asset management after 1997 was driven by high fee alternative investments, with little direct evidence of much social benefit, and potentially large distortions in the allocation of talent. On net, society is likely better off because of active asset management but, on the margin, society would be better off if the cost of asset management could be reduced. Second, changes in the process of credit delivery facilitated the expansion of household credit, mainly in residential mortgage credit. This led to higher fee income to the financial sector. While there may be benefits of expanding access to mortgage credit and lowering its cost, we point out that the U.S. tax code already biases households to overinvest in residential real estate. Moreover, the shadow banking system that facilitated this expansion made the financial system more fragile…

Finance does six things:

  • Payments--so that your web of exchange can span the world, rather than just be limited to people you know well and can trust not to welsh on the deal

  • Security--so that your command over economic resources can remain yours even when they are not under your eyes 24/7/365.

  • Temporal mismatch--I have income now but want to spend it in the future, while you want to spend now but won't have income until the future.

  • Diversification and insurance.

  • Aligning incentives--to reduce moral hazard, and raise the chances that agents actually act like agents.

  • Rewarding research--making it profitable for somebody to actually do the work of figuring out the future of the economy rather than just free-riding on the information in the market.

Comparing finance today with finance of the past--the 1950s, say--what have we got?

  • ATMs
  • The CAPM and EMH
  • Vanguard
  • Junk bonds and takeover artists--to the extent that what is going on is not some form of breach-of-trust

Payments is better--but "payments being better" doesn't increase but shrinks the share of finance in GDP. Security--the rule of law holds now, but the rule of law held in 1960, and my impression is that my mother right now has less knowledge of what risks she is running with her financial asset portfolio than my grandfather and his brothers had in the 1960s when they would sit outside in the Maine summertime eating lobster and pouring over the Wall Street Journal and Value Line.

But are people--really--more diversified? Certainly the shareholders of Citigroup were very surprised in 2008 to find out that their equity was a leveraged bet on the U.S. housing market on nothing else. And are incentives better aligned? Ditto. Are we providing better incentives for research in fundamentals? I would like to see some evidence "yes"--certainly if we were we should see ourselves making better capital-allocation decisions and thus seeing faster productivity growth, but if it is there, it isn't obvious.

Temporal mismatch is also better, but I, somewhat strangely, find this a source of worry…

Let me back up: On my way down here this morning, while walking to the Rockridge BART, I stopped at La Farine at 6233 College Ave. and bought coffee and a croissant. It was clear why I did this: I had generalized purchasing power in my pocket but neither coffee nor anything to eat; they had 40,000 calories of croissants and similar on display and there were only two of them, plus they had LD50 of coffee--and thus we had very different marginal rates of substitution, and it was a win-win transaction.

The only caveat is that croissants do not grow on trees in the environment of evolutionary adaptation. Evolution has not designed my pancreas to deliver the insulin spike needed to deal when the white flour of the croissant hits my bloodstream, and my internist tells me my pancreas has only a limited future life left--so as a left La Farine I reoptimized, took two bites, and threw the croissant to the pigeons.

How much of the temporal shifting activity that our modern financial system allows us is of the same order--things that are not really win-win utility-wise, but things that we would not do if we were in our right minds, or could figure out what our right minds are?

And there is the deeper problem. The exchange of coffee and croissants for cash is--if you are willing to accept the load on your pancreas--clearly win-win: a source of utility for both parties, as the commodities are dissimilar and endowments are dissimilar and marginal rates of substitution differ. But in finance it is only cash. How can marginal rates of substitution differ in cash-for-cash trades? Well, there is cash at different times--that is the temporal-shifting. There is cash in different states of the world--that is insurance and diversification. There is purchasing rule-of-law and agency--that is moral hazard.

But how many of the transactions we will see today are genuinely win-win transactions impelled by temporal substitution or insurance and diversification or matching incentives? And if any transaction isn't driven by those motives, then somebody is not in their right mind.

In general when conducting this kind of an assessment of the social value of a sector, we proceed by pointing out that everyone involved in the transaction is willing and that there is an absence of nonpecuniary externalities, and so we conclude that it must be a very good thing.

In finance, I don't think we can honestly and honorably do that. I think we have to, instead, look at the social goals that the sector is supposed to attain and the cost at which it purports to attain them. And thus I am much more pessimistic than the authors here.