While the Occupy Wall Street movement regards Wall Street greed as the reason for all the money sloshing around lower Manhattan, new academic research suggests that today’s huge appetite for trading may explain the financial industry’s large size.
In a paper titled “Has the finance industry become less efficient? Or where is Wal-Mart when we need it?” Thomas Philippon, a finance professor at NYU’s Stern School of Business, observes that the cost of financial intermediation has been steadily rising since the 1970s–a trend he calls counterintuitive given the cost-reducing surge in IT during that same time period.
Looking at historical data reaching all the way back to 1870 when J.P. Morgan (left) ruled, Philippon finds that the cost of financial intermediation has shifted many times, from a low of 1.3% of GDP to a high of 2.3% of GDP. Economic modeling would suggest a lowering of those costs over time as a result of technological improvements. “Essentially, the physical transaction costs of buying and holding financial assets must have decreased because of IT,” Philippon conjectures. “This effect must have lowered the amount spent on intermediation.”
Yet we are at peak costs today at exactly the time when IT has dramatically reduced costs in other industries. “Based on what we see in wholesale and retail trade, IT should have made finance smaller, not larger.” (Hence, Philippon’s title question about Wal-Mart, whose IT-based efficiency has shrunk retail’s intermediation costs.)