Thomas Philippon's 28-page PDF Has the U.S. Finance Industry Become Less Efficient? is an important analysis for anyone interested in understanding our debt-strapped economy. Philippon lays out his method and his conclusion in the Abstract:
I measure the cost of [financial] intermediation on the one hand, and the production of assets and liquidity services on the other. Surprisingly, the model suggests that the finance industry has become less efficient: the unit cost of intermediation is higher today than it was a century ago.
He gets to his evidence in the first paragraph:
The sum of all profits and wages paid to financial intermediaries represents the cost of financial intermediation. I measure this cost from 1870 to 2010, as a share of GDP, and find large historical variations. The cost of intermediation grows from 2% to 6% from 1870 to 1930. It shrinks to less than 4% in 1950, grows slowly to 5% in 1980, and then increases rapidly to almost 9% in 2010.
So before I'm two paragraphs in, I know how Philippon's story differs from mine.
The cost Philippon considers is the cost of wages and profits associated with finance and insurance. (The relevant statistics are often categorized as FIRE -- Finance, Insurance, and Real Estate -- but Philippon goes out of his way to exclude real estate.)
The PDF, basically, is an examination of wages and profits in the whole economy versus wages and profits in the financial sector alone. This is a reasonable approach, for the Statistical Abstract and other sources have long presented the numbers broken down into "Financial" and "Nonfinancial" categories.1 Philippon simply extends this breakdown to GDP itself.
In The Wealth of Nations, Book One, Chapter VI: Of the Component Parts of the Price of Commodities (summarized here), Adam Smith identified three categories that are today described simply as "land, labor, and capital." Smith wrote:
In every society the price of every commodity finally resolves itself into some one or other, or all of these three parts; and in every improved society, all the three enter more or less, as component parts, into the price of the far greater part of commodities.
The revenue derived from from labor is called wages. That derived from stock, by the person who manages or employs it, is called profit. The revenue which proceeds altogether from land is called rent, and belongs to the landlord. All taxes, and all the revenue which is founded upon them, all salaries, pensions, and annuities of every kind, are ultimately derived from some one or other of those three original sources of revenue.
From my perspective -- and Adam Smith's, I daresay -- the wages and profits of finance belong in the same categories as the wages and profits of the Nonfinancial sector, for they are payments to labor and to capital.
Philippon is doing good work. Exciting work, really, remarkable as that is in the field of economics. But he is looking at two of Smith's categories and for those categories he un-resolving the totals into separate subtotals. I do something completely different.
Money is a raw material of production, just as much as the oil or the soil; but it is not a product of nature, so it cannot be counted with land and its payment, rent. Nor is interest the same as profit or wages, as Adam Smith understood.
"The interest of money is always a derivative revenue," Smith said, derived from wages or from profit or from rent. In other words, interest is a cost different from wages and profits and rent, but evidently is one of the things that prices resolve into.
Wages, profit, and rent, are the three original sources of all revenue as well as of all exchangeable value. All other revenue is ultimately derived from some one or other of these.
Interest is not the same as wages. Nor is it the same as profit, as Smith points out. And it is not the same as rent as Smith used the term. So I am changing his definition, and counting "the interest of money" as a fourth original source of revenue.
In Smith's day there was an aristocracy, which owned the land; and there were laborers; and there was a growing business class. Three categories. Today little remains of the aristocracy. The growth of finance has created a new major cost category in the global economy. Thus it is counted in the statistics, and so it is considered on this blog.
Philippon considers as financial cost only the income to people working in finance. On my definition, Adam Smith's revised definition, this is not Financial cost. Just as wages are the payment to labor and profit is the payment to capital, interest is the payment to finance. And the payment to any sector is economic cost.
My approach to financial cost is completely unlike Philippon's. Both approaches matter. But if you are satisfied to think of the wages and profits in the financial sector as the full measure of the cost of finance, you are missing the bigger picture.
1. In the 1970 edition of the Statistical Abstract, the first table in the Banking, Finance and Insurance section, Table 638, presents Flow of Funds accounts for "Financial and Nonfinancial Institutions".
But I searched the whole Banking and Finance section of the 1960 edition and turned up only one relatively minor table that separated out financial institutions: Table 582, Consumer Installment Credit, By Holder.
In the Business Enterprise of that 1960 edition, Finance is presented as one among several categories of enterprise, as in Table 620, Number of Firms in Operation.
The special treatment of Finance goes back at least to 1970, but not to 1960.