The Growth of Finance

Robin  Greenwood; David S. Scharfstein

Article | Journal of Economic Perspectives | Spring 2013

The Growth of Finance

by Robin Greenwood and David S. Scharfstein

Abstract

The U.S. financial services industry grew from 4.9% of GDP in 1980 to 7.9% of GDP in 2007. A sizeable portion of the growth can be explained by rising asset management fees, which in turn were driven by increases in the valuation of tradable assets, particularly equity. Another important factor was growth in fees associated with an expansion in household credit, particularly for residential mortgages. This expansion was itself fueled by the development of non-bank credit intermediation (or "shadow banking"). Whether the growth of the financial sector has been socially beneficial depends on one's view of active asset management, the increase in household credit, and the growth of shadow banking. While recognizing some of the benefits of professional asset management, we are skeptical about the marginal value of active asset management. We then raise concerns about whether the potential benefits of increased access to household credit—the main output of the shadow banking system—are outweighed by the risks inherent in this new approach to credit delivery.

Keywords: Asset Management; Research; Finance; Mortgages; Financial Services Industry;

Format: Print

Read Now

Citation:

Greenwood, Robin, and David S. Scharfstein. "The Growth of Finance." Journal of Economic Perspectives 27, no. 2 (Spring 2013): 3–28.

We develop a model in which risk-averse, specialized bond investors must be paid to absorb shocks to the supply and demand for long-term bonds in two currencies. Since long-term bonds and foreign exchange are both exposed to unexpected movements in short-term interest rates, our model naturally links the predictability of long-term bond returns to the predictability of foreign exchange returns. Specifically, a shift in the net supply of long-term bonds in one currency influences bond term premiums in both currencies as well as the foreign exchange rate between the two currencies. Our model matches several important empirical patterns, including the co-movement between exchange rates and bond term premiums as well as the finding that central banks' quantitative easing policies impact not only local-currency long-term yields, but also foreign exchange rates. We also show that this quantity-driven approach provides a unified account explaining both why foreign exchange tends to outperform when the foreign interest rates exceed domestic rates and why long-term bonds tend to outperform when the yield curve is steep.

We develop a model of government portfolio choice in which a benevolent government chooses the scale of risky projects in the presence of market failures and tax distortions. These two frictions generate motives to manage social risk and fiscal risk. Social risk management makes attractive programs that ameliorate market failures in bad economic times. Fiscal risk management makes unattractive programs that entail large government outlays at times when other programs in the government's portfolio also require large outlays. We characterize the determinants of social and fiscal risk and argue that these two risk management motives often conflict. Using the model, we explore how the attractiveness of different financial stability programs varies with the government's fiscal burden and with characteristics of the economy.

Faculty & Research

The Growth of Finance

Abstract

Citation:

About the Authors

More from these Authors