Our nation's financial sector reportedly is shrinking. That is a good thing, even if many of the reports in the financial press have a mournful tone.
In the go-go years leading up to 2007, we let the cart of finance get way ahead of the horses of commerce and industry. Getting things back in proportion is a healthy correction.
Start by understanding the role of financial institutions in an economy. Efficient production of goods and services depends, among other factors, on mechanisms to facilitate the flow of resources from savers to borrowers.
These mechanisms may be commercial banks that accept deposits and make loans. They may be insurance companies that take in premiums and invest them in real estate, stocks and bonds. They may be retirement and mutual funds that accept savings from households and invest it in various ways. And they may be investment banks that assist other businesses in raising capital by issuing new stocks and bonds.
People often don't understand the importance of such financial intermediation. Some, particularly to the left of political center, view most financial companies with great suspicion.
However, those of us who have lived or worked in poor countries that lack efficient and competitive banks or where most households have no access to insurance or any means of storing value other than in physical goods or real estate, know that a financial sector fulfills critical functions in a society.
Facilitating the flow of money from savers to borrowers is the primary one. There are others. Banks give households and businesses a way of making payments via checks, credit and debit cards, and electronically. Insurance companies provide a means of managing risk. And the banking system is the mechanism by which a central bank, by controlling the money supply, transmits the effects of its policy changes to the economy.
Remember that the ultimate end of production is consumption. That is, economic activity serves to turn available resources into goods and services that meet the needs of people. Some activities of financial services, especially the payments system and insurance, are final services that go directly to households. But most of the activities in the sector are intermediate steps to help produce “final goods” for consumers. They are services to businesses involved in producing goods or services that ultimately benefit people.
The transportation system is a good analogy. A fraction of it, especially airlines, moves us or our possessions around. But most trucks, trains, barges and pipelines are moving raw materials or intermediate goods between businesses or hauling finished items to retailers. Transportation is vital, mostly because it makes other productive sectors viable or more efficient.
The same is true for finance. Most financial activity is to facilitate production of final goods and services by other businesses.
As such, activities of financial firms historically contributed about 4 percent of gross domestic product and roughly the same fraction of business profits and employment. Going to work in banking, insurance or on Wall Street was a good career option, but compensation was not vastly higher than in other businesses.
However, in the decade before the bubble popped, finance grew to over 7 percent of GDP.
By 2007, financial firms were reaping some 40 percent of all corporate profits. Graduates with good math skills and physics or engineering degrees were forsaking careers in manufacturing, electronics and computers for much higher-paying jobs as quantitative analysts on Wall Street.
Some hailed this as evidence of a new economy. Salaries and bonuses were high because Wall Street was supposedly creating enormous value for society.
But it was exceedingly difficult to see how this was actually meeting the needs of individuals and families.
The financial tail was wagging the dog of the broader economy, but this became clear to many of us only in retrospect.
Yet all the signs were there. Financial companies were getting increasing proportions of their profits from proprietary trading, including in derivatives and currencies, rather than traditional banking, insurance and securities underwriting.
Many economists offered the traditional defense that speculators perform a beneficial service by adding liquidity to markets and by absorbing risks others want to shed. Furthermore, it became nearly impossible to differentiate between socially useful speculation and harmful speculation.
This is all true, but we also understand the principle of decreasing returns.
When the total national value of credit default swaps reached four times the value of all the goods and services produced in our country in a year, or when daily trading volumes in currency markets reached comparable levels, we should have known things were getting out of kilter. Now we do.
So when you read that employment, compensation and corporate profits are dropping for Wall Street firms, that largely represents a healthy return to normality. When you see a headline like one I saw the other day: "Glory Days of Currency Trading Are Over," consider it good news.
The speculative end of the financial sector may be shrinking, but a handful of companies remain so large they are a threat to the stability of our economy. These also wield disproportionate power in Washington, and neither major party shows any willingness to break them up.
Furthermore, when over 70 percent of stocks traded on U.S. exchanges result from high frequency trading, gaps between benefits to individual firms and benefits to society as a whole continue to be large. We have a way to go, but at least some of the trends are in the right direction.
Economist Edward Lotterman teaches and writes in St. Paul, Minn. Write him at firstname.lastname@example.org.