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August 5, 2015

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Posted: 05 Aug 2015 12:06 AM PDT

'Sarcasm and Science'

Posted: 04 Aug 2015 10:20 AM PDT

On the road again, so just a couple of quick posts. This is Paul Krugman:

Sarcasm and Science: Paul Romer continues his discussion of the wrong turn of freshwater economics, responding in part to my own entry, and makes a surprising suggestion — that Lucas and his followers were driven into their adversarial style by Robert Solow's sarcasm...
Now, it's true that people can get remarkably bent out of shape at the suggestion that they're being silly and foolish. ...
But Romer's account of the great wrong turn still sounds much too contingent to me...
At least as I perceived it then — and remember, I was a grad student as much of this was going on — there were two other big factors.
First, there was a political component. Equilibrium business cycle theory denied that fiscal or monetary policy could play a useful role in managing the economy, and this was a very appealing conclusion on one side of the political spectrum. This surely was a big reason the freshwater school immediately declared total victory over Keynes well before its approach had been properly vetted, and why it could not back down when the vetting actually took place and the doctrine was found wanting.
Second — and this may be less apparent to non-economists — there was the toolkit factor. Lucas-type models introduced a new set of modeling and mathematical tools — tools that required a significant investment of time and effort to learn, but which, once learned, let you impress everyone with your technical proficiency. For those who had made that investment, there was a real incentive to insist that models using those tools, and only models using those tools, were the way to go in all future research. ...
And of course at this point all of these factors have been greatly reinforced by the law of diminishing disciples: Lucas's intellectual grandchildren are utterly unable to consider the possibility that they might be on the wrong track.

'The US Financial Sector in the Long-Run: Where are the Economies of Scale?'

Posted: 04 Aug 2015 10:20 AM PDT

 And one more  before heading out the door. From Tim Taylor:

The US Financial Sector in the Long-Run: Where are the Economies of Scale?: A larger financial sector is clearly correlated with economic development, in the sense that high-income countries around the world have on average larger markets for banks, credit cards, stock and bond markets, and so on compared with lower-income countries. But there are also concerns that the financial sector in high-income countries can grow in ways that end up creating economic instability (as I've discussed herehere, and here). Thomas Philippon provides some basic evidence on the growth of the US financial sector over the past 130 years in "Has the US Finance Industry Become Less Efficient? On the Theory and Measurement of Financial Intermediation," publishes in the April 2015 issue of the American Economic Review (105:4, pp. 1408–1438). The AER is not freely available online, but many readers can obtain access through a library subscription.

There are a couple of ways to think about the size of a country's financial sector relative to its economy. One can add up the size of certain financial markets--the market value of bank loans, stocks, bonds, and the like--and divide by GDP. Or one can add up the economic value added by the financial sector. For example, instead of adding up the bank loans, you add up the value of banking services provided. Similarly, instead of adding up the value of the stock market, you add up the value of the services provided by stockbrokers and investment manager.

Here's a figure from Philippon showing both measures of finance as a share of the US economy over the long run since 1886.

The orange line measured on the right axis is "intermediated assets," which measures the size of the financial sector as the sum of all debt and equity issued by nonfinancial firms, together with the sum of all household debt, and some other smaller categories. Back in the late 19th century, the US financial sector was roughly equal in size to GDP. By just before the Great Depression, it had risen to almost three times GDP, before sinking back to about 1.5 times GDP. More recently, you can see the financial sector spiking with the boom in real estate markets and stock markets in the mid-2000s at more than 4 times GDP, before dropping slightly. The overall trend is clearly up, but it's also clearly a bumpy ride.

The green line shows "finance income," which can be understood as a measure of the value added by firms in the financial sector. For the uninitiated, "value added" has a specific meaning to economists. Basically, it is calculated by taking the total revenue of a firm and subtracting the cost of all goods and services purchased from other firms--for example, subtracting costs of supplies purchased or machinery. In the figure, most of the "value-added" that measures  "finance income" includes all wages and salaries paid by a firm, along with any profits earned.

An intriguing pattern emerges here: finance income tracks intermediated assets fairly closely. In other words, the amount paid to the financial sector is more-or-less a fixed proportion of total financial assets. It's not obvious why this should be so. For example, imagine that because of a rise in housing prices, the total mortgage debt of households rises substantially over time, or because of rising stock prices over several decades, the total value of the stock market is up. Especially in an economy where information technology is making rapid strides, it's not clear why incomes in the financial sector should be rising at the same pace. Does a bank need to incur twice the costs if it issues a mortgage for $500,000 as compared to when it issues a mortgage for $250,000? Does an investment adviser need to incur twice the costs when giving advice on a retirement account of $1 million as when giving advice on a retirement account of $500,000? Shouldn't there be some economies of scale in financial services?

Philippon isn't the first to raise this question: for example, Burton Malkiel has asked why there aren't economies of scale in asset management fees here. But Philippon provides evidence that, for whatever reason, a lack of economies of scale has been widespread and long-lasting in the US financial sector.

Full disclosure: The AER is published by the American Economic Association, which is also the publisher of the Journal of Economic Perspectives, where I have worked as Managing Editor since 1986.

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