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How Big Is Too Big? On the Social Efficiency of the Financial Sector in the United States (Thomas Weisskopf Festschrift Conference Paper)
Abstract:
In the aftermath of the 2008-09 financial crisis, many observers have concluded that the U.S. financial system has grown to excessive size relative to the economy’s non-financial sectors. But as Epstein and Crotty explore in this paper, there does not yet exist any carefully derived theoretical frameworks or metrics to measure the social usefulness of financial activities.  Yet having such measures could become the basis for establishing the desirable size of the financial sector relative to the rest of the economy. 

Epstein and Crotty undertake an initial exploration on ways to conceptualize the U.S. financial sector’s appropriate size and quality.  They then marshal some initial data on the social efficiency of the financial sector in financing real economy activity and the social purpose of financial innovation.  They also consider the social purpose of other activities by the financial sector, including liquidity provision and market making.   They conclude that what they term “income extraction” by the financial sector has grown significantly over the post World War II period in the U.S. relative to its useful contributions to broader economic well-being.  They provide preliminary empirical estimates as to the magnitude of these “income extraction” activities by U.S. investment banks as a proportion of their useful economic contributions. They conclude from this preliminary research that “the financial sector may need to be only one-half to one-quarter as large as it is currently to serve the existing needs of the real sector.”

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