financial services, as a share of the value-added in GDP, are about 7-8% of GDP in recent decades, according to the US Bureau of Economic Analysis (see the “Value added by Industry as a Percentage of Gross Domestic Product” table, line 55). Thus, the question is why the financial services accounts for 7-8% of GDP, but about 25-30% of all corporate profits.
Taylor raises some possible answers, but wisely reaches no conclusion. Anyone who claims to know the answer is deluded.
To start with, it is important to point out that accounting profits are not the same as true profits, which economists call rents. I have some intuition about what generates economic rents: regulatory advantages and/or shielding from competition come to mind.
In the case of banks, especially the “primary dealers” that trade with the Fed, I have a darkly cynical hypothesis. That is, for all of the supposed “mandates” given to the Fed—the mandate to pursue price stability, full employment, economic justice, climate risk mitigation—the Fed behaves as if it has One True Mandate. The One True Mandate is to ensure the health of the leading banks. It can tolerate inflation, recessions, etc., as long as the banks are ok.
I can recall one instance in which the Fed did not follow the One True Mandate. That was when they let Lehman fail in 2008. That might have been because Hank Paulson did not like Dick Fuld, and Paulson was a sufficiently forceful personality that he had his way with Bernanke and the Fed.
But back to the issue of financial sector profits. I don’t have strong intuition about what generates the profits that show up in accounting statements, including the national income accounts. Conventionally defined profits are a residual, or leftover. When firms receive revenue, profits are what is left over to distribute to shareholders or reinvest in the business after everyone else has been paid: suppliers, employees, lenders. A portion of pre-tax profits then goes to the government, leaving after-tax profits as the leftover.
If we were talking about economic rents, scaling them relative to value added in GDP would have intuitive appeal. But for leftovers the right scaling metric is more likely to be equity investment. If some investors put in $100 million to start a bank and some other investors put in $25 million to start a factory, the profits (leftovers) of the bank ought to be greater than the profits of the factory, even if the factory produces output with more measured value in GDP.
I have questions about how to measure equity investment for this purpose. Using the current market capitalization of the firm does not seem right. Maybe what I want is the sum total of funds raised in equity markets. But a dollar raised twenty years ago should count for more than a dollar raised last month.
I also have questions about how to measure the output of financial services. As Taylor puts it
the way in which GDP measures the value-added of the financial services sector may tend to understate the size of the sector. After all, it’s hard to separate out what the financial sector produces into changes in quantity of services produced, changes in the quality of those services (as financial technology evolves), and price for each service.
The accountants know how much the banks collected in fees, but is that a reliable measure of value? The financial system is supposed to allocate capital, but the GDP accountants at the Department of Commerce have no clue how to measure something like “the skill or lack thereof with which banks helped with capital allocation this year.”
There are similar challenges in measuring output in education or health care, but from one year to the next teachers and doctors don’t do much better or much worse (setting aside performance during the pandemic). Performance in the financial sector appears to be highly volatile.
We are entitled to wonder if the financial sector really earns its share of profits in the economy. In the end, all I can say is that it is a very hard question to answer.
"We are entitled to wonder if the financial sector really earns its share of profits in the economy. In the end, all I can say is that it is a very hard question to answer."
It does not, and it itsn't.
GDP is a gamed, garbage metric that conflates money flow with actual goods and constructive services (e.g. services which add to productive capacity).
The financial sector is almost wholly parasitic, and a knock-on effect of the financialization of our economy by banksters & oligarchs that have bribed and (often pedo-sexually) blackmailed our government apparatchiks into engineering the system to enrich them at the expense of everyone else.
This is about to become painfully apparent to even midwits.
Pretty sure nearly all banking profits would be wiped out in periodic banking crises if not for the govt backstop. So maybe 7-8% of GDP is the value-add and the rest is the value of the backstop.