Source: The Evolution of the US Financial Industry from 1860 to 2007: Theory and Evidence. NBER.
A Historical Overview
A financial industry plays an important role in any modern economy. It provides widely varying principal and intermediation services to households and corporations—services that sometimes are simple, but often complex. The services range from lending, to stock brokerage, to complex securities, to real estate and insurance, among many others.
The industry has changed considerably in its importance over the last 160 years. As Figure 1 shows, the U.S. industry's share of domestic GDP was at its lowest during the mid-nineteenth century, when it hovered between 1 percent and 2.5 percent. From 1900 to 1930, however, it rose steadily, before peaking at approximately 6 percent of GDP at the beginning of the Great Depression. It then fell sharply in importance over the next fifteen years. The industry resumed its rise in 1945 and has yet to peak, having touched 8.4 percent of U.S. GDP in the last two years.
Why the industry has changed in relative importance over time is a crucial question. After all, unlike other sectors, in a true Arrow-Dubreu economy, the financial services industry would not exist in anything like its present form. Its intermediating functions would be simple and, thus, readily provided by a much smaller and less-profitable sector. Such is demonstrably not the case, however, so it is worth considering why the industry has grown to be as large and systemically important as it has become.
Across its history, the financial services industry's periods of more-rapid growth have generally been tied to periods during economic history when the need for financial intermediation was growing sharply. For example, the financial services industry's rise in the late nineteenth and early twentieth centuries corresponded to the appearance of railroads and early, large-scale manufacturing. Its next sharp rise, in the 1930s, corresponded to the build-out of the U.S. electrical grid, as well as rapid growth in the automobile and pharmaceutical industries. We subsequently can see a sharp increase in financial services as a percentage of GDP from 1980 to the late 1990s, with a proximate cause this time being the financing of waves of information technology, culminating in the Internet boom.
Not all periods of more-rapid U.S. economic growth have, however, coincided with a significant increase in financial services' relative role in the economy. For example, as the above figure shows, the 1960's were a period of substantial economic growth, but were accompanied by only a tiny increase in financial services' growth as a percentage of GDP.
In general, however, and most importantly for this paper, there should be no question that the financial services sector plays a key role for entrepreneurs. It helps reduce moral hazard, while mitigating adverse selection problems that otherwise might exist for young companies that lack long track records or significant collateral. To pretend otherwise—to pretend that we can have widespread entrepreneurial capitalism in the absence of a significant and active financial services sector—is to be fanciful. At the same time, however, financial services and entrepreneurial ventures compete in the economy for many of the same employees. Given that the social returns from entrepreneurial efforts generally are higher than the private ones, this can be a source of allocative inefficiency in the economy, one with potentially material consequences.
Having said the preceding, all observers of the U.S. economy should be concerned when the financial sector's activities increasingly feed back on the sector, rather than on the "real" economy. We have recently seen a consequence of the 2008 financial crisis. There are more and other consequences, and we focus on some of them in this paper—in particular, the effect of financial services growth and capital misallocation on young, growth companies. As John Maynard Keynes memorably said, "When the capital development of a country becomes the byproduct of the activities of a casino, the job is not likely to be well done."