- There can be no doubt that a healthy economy and society depend on a healthy financial system. But what do we mean by a healthy financial system? Is it one that provides simple intermediary services to the so-called "real," or nonfinancial, economy? Or can it be more than that without cannibalizing the rest of the economy's vital organs?
- The Kauffman Foundation recently addressed this issue in a paper by Paul Kedrosky and Dane Stangler, "Financialization and Its Entrepreneurial Consequences." The authors recognize that the financial services sector plays a key role for entrepreneurs, providing systems for obtaining funding and managing cash flow, which might otherwise be inaccessible. But when the financial sector becomes too large, as they argue it has in the U.S., it drains talent from entrepreneurial ventures, thereby depleting our economic strength.
- Since the end of World War II, the financial industry as a percentage of GDP has quadrupled to its present 8.4%, offering spectacular rewards to those capable of profiting from it.
- Kedrosky and Stangler, however, argue that the net effect of this has been negative, as too much financialization may have stifled the creation of new firms. Per-capita rates of firm formation today are lower than they were in the early 1980s. Growth in financial services is not entirely to blame, of course. But it does appear to have leached away talent and capital from new businesses which might have created more jobs and greater long-term wealth for the economy than yet another hedge fund.
- Any visitor to a college campus in recent years can tell a story of talented students in engineering, technology or even liberal arts seduced away from these professional paths by the financial lures of banks, hedge funds or private equity firms. Brilliant computer scientists forgo the risks and opportunities of building the next Google, for the surer bet of designing algorithms for a hedge fund. Gifted physicists abandon research to build multilayered derivatives for Goldman Sachs. These employees no longer serve the rest of the economy, but rather spend their time engineering products to tilt the markets in their favor.
- Between 2003 and 2006 the percentage of graduates from MIT going into financial services rose from 13% to almost 25%. (quite amazing) Financial services hiring among Harvard Business School's M.B.A. class fell from 40% to 30% between 2007 and 2008, but was back up to 34% last year. A mere 12% went into general management roles, supposedly the purpose of the school's curriculum.
- Glancing at the incentives, one can hardly blame these young hires. Financial firms offer considerably higher pay, better career prospects and insulation against off-shoring, than traditional science and engineering companies. Human capital, like financial capital, is attracted to opportunities with the highest risk-adjusted returns.
- Imagine if Larry Page and Sergey Brin had applied their talents to trading rather than Internet search? Not only might it have taken them longer to build their multibillion-dollar fortunes, but the world would have been deprived of Google. Our suspicion is that the easy lures of finance have robbed us of more than one Google.
- Kedrosky and Stangler also note that highly skilled graduates have migrated into financial services just as financing opportunities have expanded for entrepreneurs. So now we find ourselves in the strange situation where more money is going into startups that have lower-quality founders and thus lower chances of success. This is the stuff of destructive economic bubbles.
The rest of the article is about "what should be done" but it is quite vague on ideas - frankly it is impossible without any change to the incentive system, which will never happen. Ironically, at some point the financial sector had become a leech on the system - rather than serving the economy, the economy now serves the financial sector. When the market tried to course correct this issue in 2008... well that's where your hard earned tax dollars came in to make sure the status quo remained. Booyah.