By Wouter den Haan, Professor of Economics, London School of Economics and CEPR Research Fellow (this article first appeared on VoxEU)

This column launches a new Vox Debate titled “Why do we need a financial sector and how much should we pay for it”. The column argues standard measures of the financial sector’s economic contribution overestimate its true value to a modern economy. As such, regulation that makes it more difficult for the sector to perform some activities is not necessarily a bad thing.

According to national-income account data, financial institutions are responsible for an important fraction of what countries produce each year. A standard way to measure a sector’s contribution to GDP is to calculate its value added, that is, the difference between the value of the products produced minus the value of the products used in production.

This “value added” is distributed as income or reinvested in the financial sector.

  • Figure 1 displays the fraction of US GDP produced by the financial and insurance sector. During the post-war period this fraction increased from 2% to 8%.
  • The UK’s financial sector generated 9% of total British value added in the last quarter of 2008; this was only 5% in 1970.1

Figure1. Value added of the finance and insurance sectors in the US (% of GDP)

Source: Bureau of Economic Analysis

An increase in inputs (capital and labour) is only part of the story. Value added per worker has also increased substantially. Weale (2009) reports that earnings per employee in the UK financial sector were 2.1 times average earnings in 2007. In Philippon and Reshef (2008), it is shown that the rise in the relative financial wage is related to financial deregulation.

The elevated position of the financial sector is even more obvious when we take a look at corporate profits.

  • In the first couple of decades following the Second World War, profits in the financial sector were around 1.5% of total profits;
  • Recently, this number was as high as 15%.

Pay versus output

Without doubt, these numbers indicate that the stakeholders in the financial sector (employees and investors) receive a substantial chunk of GDP. But the numbers do not necessarily imply that the sector produces this much. Nor do they imply that the actual value of what the sector produces has gone up a lot during the post-war period.

To understand why there could be a difference between the income received and the value of what is being produced, consider the basis of this deduction. In a competitive economy, the price of a good equals its marginal cost, and consumers buy it up to the point where their marginal benefit equals the price. If it is an intermediate good, the price equals the value of the good’s marginal productivity to the purchasers. Thus, the value of output works well as a measure of both the cost and the benefit to society. That’s the magic of the market.

However, if the sector is imperfectly competitive, the price will exceed the social marginal cost and we’ll see value added being artificially transferred between sectors. As the financial sector is very concentrated, this is one reason we should expect the payments to factors in banking to exceed the value created – taking, as a base case, the prices that would be observed if the sector were competitive.

A second wedge between wage and value arises from the implicit insurance that the financial sector gets. As financial service providers do not pay for the “moral hazard” they create, the true value of financial services is systematically less than the payment to factors. Curry and Shibut (2000) calculate that the fiscal cost, net of recoveries, of the 1980s US Savings and Loan Crisis was $124 billion, or roughly 3% of GDP. This cost ignores other costs such as output losses, and this was a relatively mild crisis. Laeven and Valencia (2008) consider 42 crisis episodes and find an average net fiscal cost of 13.3%.2 It would not be fair to attribute these losses solely to the financial sector, but the magnitudes of the numbers suggest that this wedge could quantitatively be very important.

A third wedge comes from negative spillovers. The financial sector may provide services that are useful to a client, but not to society as a whole. For example, a financial institution may help to structure a firm’s financing in such a way that the firm pays less taxes. Such a transaction would not increase production, unless lower taxes help the firm to produce more. Nevertheless, such transactions will count as value added generated by the financial sector. A rather stark analogy could be drawn with the cigarette industry, where it is quite clear that the payments to factors do not really measure social value added since the cost of smoking-induced health problems falls on the taxpayer (in most nations).

Although the sector’s contribution is not easy to measure, there are some things we do know.

  • First, the financial sector provides useful services. That is, the sector’s value added should be positive.
  • Second, financial-sector value added reported in the national income accounts was probably overvalued in the years leading up to Great Recession.

The financial sector extracted huge fees from the rest of the economy to construct opaque securities that were so complex that only a few understood how risky they were.3 If fees (prices) had accurately reflected the true value of the products, then some of these fees should have been negative, since many such products were not beneficial to the buyer or to society as a whole.

Several important questions need answers.

  • What are the reasons for the observed substantial increase in the share of GDP received by the financial sector?
  • What are the services that the financial sector in today’s world does (or should) provide that increase the production of things we care about?
  • What is the value of these services? This is a tough question for the type of products delivered by the financial sector, because the nature of the services changes over time. For products like computers, we can measure characteristics such as speed and memory and measure how much computing power you get. If a bank becomes better at preventing default, then it provides more “financial services” for each unit of loans issued. But how can we correct for such changes in risk exposure? One possibility to measure the effectiveness of the services provided is to investigate how differences in financial sectors across countries are related to valuable characteristics such as smaller business cycles, better life-time consumption patterns, and innovative firms not facing financing constraints.4

What is the value of modern finance versus traditional finance?

Although the financial sector has been in the limelight since the outbreak of the crisis, these questions have received little attention. There is a substantial academic literature investigating the positive (and negative) effects of the presence of developed financial markets on long-term growth.5 But there is not that much research done on the question of which aspects of the current financial system are important for today’s economies.

One would think that it is essential to fully understand what contributions the financial sector, and especially banks, can offer before engaging in a discussion on how to regulate this sector. If the key aspects of the financial sector that foster growth are relatively simple, then we would not have to worry that, say, increased capital requirements would have negative impacts on the economy. Then it would make more sense to worry about there being enough competition, so that we do not pay a lot for relatively simple activities. But if sustained economic growth requires a creative financial sector capable of performing complex tasks, then we should worry that regulation is not going to debilitate this sector.

It is surprising that these questions currently get so little attention. In an abstract sense, we know what roles financial institutions fulfil. In particular, (i) financial institutions avoid duplication both when monitoring loans and collecting information, (ii) they help to smooth consumption, and (iii) they provide liquidity.6 There are many enjoyable descriptions of some activities enacted in the financial sector that seem hard to reconcile with the laudable tasks thought of by economists. Moreover, knowing what the tasks of the financial sector are in theory does not tell us whether those tasks are fulfilled efficiently and at the right price. Nor does it tell us why the income earned by the financial sector has increased so much. As pointed out by Philippon (2008), in the 1960s outstanding economic growth was achieved with a small financial sector. Has it become more difficult to obtain information so that we now need to allocate more resources to the financial sector?

Some articles in the literature address the questions posed here. Chari and Kehoe (2009) use US firm-level data and find that the amount spent on investment exceeds the amount of internally-available funds (revenues minus wages minus material costs minus interest payments minus taxes) for only 16% of all firms considered. If investment could in principal be done using the firms’ own funds, then the role for financial intermediaries is obviously diminished. Haldane (2010) discusses in detail the earnings of the financial sector and concludes that “risk illusion, rather than a productivity miracle, appears to have driven high returns to finance”. Philippon and Reshef (2008) study wages earned in the financial sector and conclude that a large part of the observed wage differential between the financial sector and the rest of the economy cannot be explained by observables like skill differences, but is likely to be due to the presence of rents. Philippon (2008) argues that an increase in the types of firms that invest (young firms) can explain part of the increased income share of the financial sector; the increase in the last decade remains puzzling.

A similar view is expressed by Popov and Smets (2011), who argue that deeper financial markets in the US relative to those of the European continent are, to a large extent, responsible for the larger increases in productivity and faster pace of industrial innovation. One piece of evidence supporting this view is the empirical study of Popov and Roosenboom (2009), who find that better access to private equity and venture capital have a positive impact on the number of patents. Den Haan and Sterk (2011) reconsider the popular hypothesis that innovations in financial markets should make it easier for financial institutions to smooth business cycles. The idea of this hypothesis is that better access to bank finance ensures that consumers and firms do not have to make decisions that are bad for the economy as a whole, such as firing workers or postponing purchases which in turn could trigger additional layoffs. Den Haan and Sterk (2011) analyse in detail the behaviour of consumer loans and real activity, and find that there is no evidence that supports the hypothesis that financial innovations dampened business cycles, even when the recent crisis is excluded. Lozej (2011) addresses the same question using firm loans. Although the evidence presented by Lozej (2011) is a bit more mixed, there is at best weak evidence that the changes in the financial sector contributed to smaller business cycles during the period before the recent crisis.


The literature indicates that some tasks of the financial sector are beneficial, some attributes of financial institutions matter, and others matter less so or not at all. The recent publication of the Vickers report is a good occasion to investigate what activities of the financial sector are beneficial for today’s way of life, and whether they are affected by proposed regulation. Without doubt, various proposed changes in regulation will be costly for the financial sector and make it more difficult for the sector to perform some activities. But that is not necessarily a bad thing. If a change would cost the financial sector, say, one billion a year but does not affect the total amount being produced, then it just means that there is an extra billion for the other sectors.


Chari, V. V., and Patrick J. Kehoe (2009), “Confronting models of financial frictions with the data“, mimeo.
Curry, T., and L. Shibut (2000), “The cost of the savings and loan crisis: Truth and consequences”, FDIC Banking Review, vol 13 no 2.
Demirguc-Kunt, Asli, Thorsten Beck, and Patrick Honohan (2008), “Finance for all? Policies and pitfalls in expanding access”, World Bank: Washington, DC.
Den Haan, Wouter J., and Vincent Sterk (2011), “The myth of financial innovation and the great moderation“, The Economic Journal 121, 707-739.
Gorton, Gary, and Andrew Winton (2003), “Financial intermediation”, in George. M. Constantinides, Milton Harris and René. M. Stulz (eds.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 8, 431-552, Elsevier, Amsterdam.
Haldane, Andrew (2010), The contribution of the financial sector – miracle of mirage?,BIS.
Laeven, Luc and Fabian Valencia (2008), “Systemic Banking Crises: A new database”, IMF working paper WP/08/224.
Levine, Ross (2005), “Finance and growth: theory and evidence”, in Philippe Aghion and Steven Durlauf (eds.), Handbook of Economic Growth, edition 1, volume 1, chapter 12, 865-934, Elsevier, Amsterdam.
Lewis, Michael (1989), Liar’s poker: rising through the wreckage on Wall Street, W.W. Norton & Company, New York.
Lowenstein, Roger (2000), When genius failed: the rise and fall of Long-Term Capital Management, Random House, New York.
Partnoy, Frank (1997), F.I.A.S.C.O.: blood in the water on Wall Street, W.W. Norton & Company, New York.
Philippon, Thomas (2008), “The evolution of the US financial industry from 1860 to 2007: theory and evidence”, manuscript New York University.
Philippon, Thomas and Ariell Reshef (2008), “Wages and human capital in the US Financial Industry: 1909-2006″, manuscript New York University and University of Virginia.
Popov, Alexander and Peter Rosenboom (2009), “Does private equity investment spur innovation”, ECB working paper 1063.
Popov, Alexander, and Frank Smets (2011), “Financial markets: Productivity, procyclicality, and policy”, manuscript European Central Bank.

 1 Unless stated otherwise, the numbers in this paragraph are from Haldane (2010).
2 The highest net fiscal cost was equal to 55.1% and attained during the 1980 Argentinian crisis. In contrast, the net fiscal cost of the banking crisis in Sweden during the early 1990s was close to zero.
3 There are many other examples. I recently transferred €10,000 from a Dutch Euro account to a Euro account held by a British bank. The transfer cost me €455. That is, a personal loss of 4.6% in one day. Given that the costs are virtually zero, the fees would be almost fully counted as value added in the national income accounts.
4 An example is Popov and Roosenboom (2009).
5 Levine (2005) provides an excellent survey and concludes that a well-developed financial sector is beneficial for growth. Demirguc-Kunt, Beck, Honohan (2008) argue that in some cases the effect could be the opposite.
6 See Gorton and Winton (2003).
7 See, for example, Lewis (1989), Lowenstein (2000), and Partnoy (1997)


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  • expat banker

    Great to see this debate has started! Three comments:

    1. I work in a large european bank and I can safely say the public sector has nothing to be ashamed of. There are some very competent people here and many average people, in general they are badly managed and so not as productive as they could be, and on average most are paid 50% more than they are worth, before bonus.

    2. The argument that US industrial innovation benefits from better access to venture capital is largely valid, but has nothing to do with the financial sector. No investment bank would touch an early stage technology company with a barge pole, it would be far too risky for them.

    3. Matt Taibbi’s comments over at Rolling Stone about why he supports Occupy Wall Street may appear over the top but are in fact well reasoned and accurate. The real question is not ‘why do we need a financial sector’ but ‘why do we tolerate such a corrupt and dysfunctional financial sector’.

  • Pod

    So, let me get this straight. The premise or assertion here is that financial services companies, in aggregate, pay their employees and shareholders vastly in excess of the value that the financial services industry creates for society.

    That means that the revenues of the financial services industry are vastly in excess of the value that their customers receive.

    That means that, in aggregate, the customer base of the financial services industry is giving the financial services industry money – cash – that is vastly greater than the benefits received by those customers.

    And, in aggregate, the customers of the financial services industry do this why? Are they stupid? Are they unable to read the price-list? Is the financial services industry holding their customers at knife-point in front of one of their ATMs?

    Unless someone can explain why the millions of individual customers of the financial services industry, through billions-and-billions of transactions, voluntarily pay said industry monies that are massively in excess of the value they receive then this would appear to be just so much academic rubbish.

  • Pod

    Unless someone can explain why the millions of individual customers of the financial services industry, through billions-and-billions of transactions, voluntarily pay said industry monies that are massively in excess of the value they receive then this would appear to be just so much academic rubbish.

    Uh, it’s called rent-seeking. It’s called fraud. It’s called federal insurance of deposits and other government policies that lower the nominal cost of services of provided.

    Really, you’d have to be completely clueless and living under a rock for the last three years not to see how modern finance has become a completely distorted market that’s consuming much more value than it provides.

  • Dan

    @pod – please read the article:

    “However, if the sector is imperfectly competitive, the price will exceed the social marginal cost and we’ll see value added being artificially transferred between sectors. As the financial sector is very concentrated, this is one reason we should expect the payments to factors in banking to exceed the value created – taking, as a base case, the prices that would be observed if the sector were competitive.”

    and yes, fraud, back-stopping by the public purse, etc.

  • Pod

    That it is an “imperfectly competitive industry” is an assertion w/o any supporting evidence. If you think the financial services industry is uncompetitive I suggest you try working in it.

  • Blissex

    The financial and health care sectors have been expanded hugely for the same reason why more and more people are pushed into longer and longer education periods, and more people are pushed into prison, etc.: to reduce “official” unemployment numbers.

    The industrial policy of the USA has been for decades to offshore unionized industries as much as possible, and to partially compensate for that by expanding employment in non-union industries, and several big name politicians and academics have been pushing the idea that the FIRE sectors are the next big employment stories.

    Basically FIRE has been greatly expanded to generate underemployment for the little people and huge bonuses and capital gains for the the people who matter.

  • Blissex

    «That means that, in aggregate, the customer base of the financial services industry is giving the financial services industry money – cash – that is vastly greater than the benefits received by those customers.»

    They don’t. That’s pure imagination.

    As Nassim Taleb points out the banks for example lose money over the cycle.

    The finance sector is as large as it is because it gets periodically recapitalized by the Fed and Treasury, as well as getting colossal subsidies by the Fed and Treasury, or they get apocalyptic regulatory forbearance from Congress.

    For example for the past several years banks have been able to borrow from the Fed at 0-1% and lend to the Treasury at 3-4%. That’s a revenue stream that they can open with a few mouse clicks.

    There is also the long-standing trickery of the “prime rate”, which has been
    set to guarantee banks a fast secure profit:

    «the spread between the Federal funds (and Treasury bill) rate and the
    prime rate widened from 1 1/2% to 3% in 1991. That was Greenspan’s gift to the
    banking sector to insure that major banks would not fail. You may recall at
    the time that rumors were rife ~ including some repeated on the floor of the
    House ~ that Citibank was about to go under. By doubling the margin between
    the prime and the funds rate ~ and essentially increasing the profitability
    fourfold after taking into consideration the costs of processing loans ~ an
    inverted yield spread lost all its meaning. And it will never return.

    As to regulatory misfeasance from Congress, some banks were allowed to triple their leverage in a special deal, and all banks have been recently allowed to mark their assets to fantasy, and their liabilities to market (or more or less whichever way they want).

    Since the users of the highly “managed” financial system even if they have few alternatives still overpay quite a lot in rent still don’t pay enough to keep it going, the government just let FIRE management run into the ground periodically with ridiculous accounting and absurd risks, and then just pumps new money in it and there it goes again.

    All to keep their best friends in Wall Street in the stunning luxury they deserve and to give so-so jobs to a few million of their employees around the country.

  • ES

    Financial industry is like police/military is required to run a capitalist state. A state needs currency in order to control its citizens.
    US treasury could’ve depostied USDs directly into citizens accounts, but that would be considered communism, I guess.
    But as long as we have middle men distributing the currency in the form of the FED and the banks, everything is just fine. Never mind that FED sets the price of money and the banks just add fees on top.

  • Blissex

    «If you think the financial services industry is uncompetitive I suggest you try working in it.»

    It is “uncompetitive” in the sense that it does not generate much value added. From a high level view a lot of it is entirely unnecessary or damaging to the rest of the economy.
    But at the individual level, or at the organizational level it is pretty cutthroat.

    The two things are not incompatible. I think that at least 50% if not 80% of current finance is essentially a fantasy-finance league, which is taken very seriously by its gamers, and some ruin their health and have strokes while playing it.

    It is a fantasy-finance league where the government periodically distributes a few trillion points (which are indistinguishable from real dollars) to the players, a gigantic set of matches happens for 15-20 years, and because the players are both messy or just pocket some of the points, eventually the government has to put on the table another few trillions points to keep the game going.

    A topical quote from J. K. Galbraith on margin trading:
    «The purpose is to accomodate speculators and facilitate speculation. But the purposes cannot be admitted. If Wall Street confessed this purpose, many thousands of moral men and women would have no choice but to condemn it for nurturing an evil thing and calling for reform. Margin trading must be defended not on the grounds that it efficiently and ingeniously assists the speculator, but that it encourages the extra trading which changes a thin and anemic market into a thick and healthy one.»

    Another topical quote from J. M. Keyes on finance:
    «When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.»

    As to the massive regulatory corruption of Congress, a currently popular recording of John Dingell repeating a of J. K. Galbraith’s warnings on the floor of the House when they voted to let Wall Stree play not just a fantasy finance league, but *extreme* fantasy finance:


    The J. K. Galbraith quote:

    «Just as Republican orators for a generation after Appomattox made use of the bloody shirt, so for a generation Democrats have been warning that to elect Republicans is to invite another disaster like that of 1929. The defeat of the Democratic candidate in 1952 was widely attributed to the unfortunate appearance at the polls of too many youths who knew only by hearsay of the horrors of those days. It would be good to know whether, indeed, we shall some day have another 1929.»

  • quark

    Unfortunately deregulating the financial sector without proper oversite is similar to printing money. Unscrupulous men and women rush in and create massive fraud knowing the likelihood of prosecution is low enough to take the risk.

    When you create money through fraud it increases hard asset prices. When you create an oversupply of widgets the price of widgets fall. Both scenarios assume an abundance of raw material.

  • JWG

    Reenact Glass Steagall, bring back leverage caps, break up the TBTFs and end the bailout culture and we will then see where financial services compensation goes. We already know that financial sector compensation was pretty good but not indefensible until it started to rise in the 1980s and then went parabolic (and indefensible) after Glass Steagall was repealed.

    Financial services at the TBTF level exist in a rigged market and benefit from a one way bet guaranteed by Uncle Sam. The TBTFs are populated by overrated and overpaid phonies whose ticket of admission is personal networking and the right schools; insider trading is endemic on Wall Street. Lend me money at 25 basis points with unlimited leverage and a government backstop if I guess wrong (with no personal liability), and the odds of getting rich are way in my favor. It is easy to hit home runs when you are swinging from second base.

  • http://www.spx500dailyindextracker.blogspot.com Klaus Bohm

    Trade Theory Financialized

    October 26, 2011
    By Michael Hudson

    Trade and Payments Theory in a Financialized Economy

    Michael Hudson (UMKC)
    Paper delivered at the Boeckler Foundation meetings, Berlin, October 29, 2011, #D3

    Kind Regards

  • Blissex

    «Unfortunately deregulating the financial sector without proper oversite is similar to printing money.»

    It is not “similar to printing money”, it is printing money, because except for physical cash, money is just credit/debit balances, and when a bank makes a loan they are printing money (restrained only by leverage ratios).

    The greatest financial “innovation” of the past few decades has been the reinvention of wildcat banking, with the largest financial institutions in NYC rather than small rural ones becoming wildcat banks thanks to the support and encouragement of Congress, Fed and Treasury.

    «Unscrupulous men and women rush in and create massive fraud knowing the likelihood of prosecution is low enough to take the risk.»

    Another quote from J. K. Galbraith “The Great Crash 1929″ seems apposite:

    «In November 1929, a few weeks after the crash, the Harvard Economic Society gave as a principal reason why a depression need not be feared its reasoned judgement that “business in most lines has been conducted with prudence and conservativism”. The fact was that American enterprise in the twenties had opened its hospitable arms to an exceptional number of promoters, grafters, swindlers, impostors and frauds. This, in the long history of such activities, was a kind of flood tide of corporate larceny.»

    I think that his book (written in 1955 about events in 1929) could be republished today with just a few names and dates changed. Some things never change: chapter 4 has title “In Goldman-Sachs we trust”. They have been doing blessed work for a long time :-).