U.S. Public Schools: Unequal Spending Across States

Mark Dixon of the U.S. Census Bureau has authored  Public Education Finances: 2011. The headline finding is that in 2011, per capita spending on K-12 education declined. The drop was a small one, only about 0.4%, but it's also the first and only drop in the last 40 years. It's yet another symptom of how brutal the Great Recession and its aftermath have been for state and local finances.

But the other pattern that especially jumped out at me from the report is the difference in what is spent per student across states--a difference that has been large for a long time. Here's a map:

For the U.S. as a whole, average public school K-12 current spending per student was $10,560 in 2011, with 61% of that going to "instruction," and 35% going to "support services." 









But four jurisdictions--New York, Wyoming, Alaska, and the District of Columbia--spend more than $16,000 per K-12 student, with New York leading the way at $19,076 per student. Conversely, Idaho, Utah, Arizona, Oklahoma,and Mississippi spend less than $8,000 per student, with Utah having the lowest tally at $6,212 per student. That is, New York spends on average three times as much per K-12 student as does Utah.

It would of course be a vulgar error to assume that high spending is what's important in K-12 education, when what actually matters is how the students achieve. Spending on education will reflect factors like the local cost of living, the extent of poverty and special needs in the state, and the legacy of past negotiations with the teachers' unions. Still, the discrepancies in what states spend is striking.

Preschool for At-Risk Children, Yes; Universal Preschool, Maybe Not

In January, I blogged in "Head Start is Failing Its Test" about a high-quality study being done by the U.S. Department of Health and Human Services, which found: "In summary, there were initial positive impacts from having access to Head Start, but by the end of 3rd grade there were very few impacts found for either cohort in any of the four domains of cognitive, social-emotional, health and parenting practices. The few impacts that were found did not show a clear pattern of favorable or unfavorable impacts for children."

In the most recent issue of the Journal of Economic Perspectives,  Greg J. Duncan and Katherine Magnuson offer a broader and modestly more  hopeful angle in their paper, "Investing in Preschool Programs,"(Like all papers in JEP back to the first issue in 1987, this is freely available on-line compliments of the American Economic Association. Full disclosure: I've been the Managing Editor of JEP since the journal started in 1987.)

 One of the main difficulties in evaluating preschool programs is that just comparing children in such  programs and not in such programs won't be a fair approach. After all, families differ in many ways, some of them not easily measureable, and these differences need to be taken into account. Thus, a preferred method is an "experimental" approach, in which out of a group of families, some are randomly assigned to the preschool program and some are not. Of course, one can then look at observable characteristics to see if the assignment was really random: that is, families with children randomly chosen to be enrolled in the preschool program should have the same average income, education level, employment level, proportion of single parents, and so on, compared with the families whose children were not randomly enrolled in the program. But random enrollment also offers a plausible way of adjusting for unobservable differences in families, like the level of emphasis that the family puts on school or persistence or work.

Duncan and Magnuson focus on the studies of preschool done with these kinds of random assignment experimental methods, and identify 84 such studies over the last half-century (including the Head Start study mentioned earlier. They summarize the results of these 84 studies in this figure.

The horizontal axis of the figure shows the year the study was done. The vertical axis shows the size of the effect found in the study, measured as the average of the cognitive and achievement gains found for those attending preschool. For perspective, the achievement gap between black and white .children entering kindergarten is about one standard deviation. Circles with a black outline are Head Start programs. The gains are measured at the end of the preschool enrollment period--before such gains have had a chance to fade out. From this figure and their surrounding discussion, here are some key points:

1) There is evidence of short-term gains from preschool programs.
2) The average level of gains from such programs seems to be falling over time (as shown by the downward-sloping line). This finding is distressing, because one would hope that such programs could become more effective over time. But a likely reason is that parents (especially the mothers) of children in these preschool program are not as deeply disadvantaged in recent years as they were back in the 1960s, when levels of literacy, health, and income were much lower. Because the parents better educated and have higher income, the gains from preschool are smaller.
3) Academic gains from preschool programs tend to fade out. As they write: "Most early childhood education studies that have tracked children beyond the end of the program treatment find that effects on test scores fade over time."
4) However, some very long-term studies have found that although measures of cognitive and achievement gains fade, there are often still observable behavioral effects like improved high school graduation rates, lower rates of teen parenthood, and lower rates of criminal behavior. This finding creates a puzzle, because even with batteries of questionnaires and tests for the children, their teachers, their parents, and others, researchers have not yet been able to measure what it is in preschool programs that might produce these positive long-term results.

So where does all of this mean for proposals for universal preschool, like the "Preschool for All" initiative announced by President Obama along with his 2014 proposed budget? I know that for some people, the word "universal" is a sort of talisman that carries echoes of equality and justice. But it's perhaps worth noting as a starting point that although preschool attendance has been increasing over time, it is far from universal now for any income group. Duncan and Magnuson provide this figure showing the share of 3 and 4 year-olds enrolled in preschool, divided up by income level. Preschool attendance has risen over the decades but it now represents about half of all children. In discussions of "universal" preschool, it's never quite clear to me whether universality is intended to apply to all income levels, or whether only the children of low-income families are to "universally" attend pre-school.

A more detailed look at the studies also suggests that there is no one-size-fits-all universal answer to the best experiences for 3 and 4 year-olds. For example, some of these studies suggest that children from low-income families benefit more than children from high-income families. Often the academic benefits of preschool are higher for girls, but the behavioral benefits are higher for boys. Children with very low birthweights often do not benefit much from preschool, perhaps because low birthweights can be a signal of reduced capabilities. Preschool programs vary quite widely how their teachers are trained, in how their classroom balance academic and emotional needs of children, and in their curriculum.  There are alternative early interventions that may be more productive for some children: for example, home visitation for high-risk, first-time mothers, or interventions for children living in families with documented domestic violence

The word "universal" is no guarantee of quality. After all, we have "universal" K-12 schooling, but that certainly doesn't mean that all children across the United States are in high-quality or even roughly equivalent schools. "Universal" is certain to be costly. There is a strong case for further experiments with an array of early childhood interventions, including preschool, to have a better sense of what works, and why. Right now, the sad truth is that there is so much we don't know. 

Spending on America's Pets

Steve Henderson of the U.S. Census Bureau pulls together data from the Consumer Expenditure Survey and looks at "Spending on pets." He writes (footnotes omitted):

"Nearly three-quarters of U.S. households own pets. There are about 218 million pets in the United States, not counting several million fish. ... Americans spent approximately $61.4 billion in  total on their pets in 2011. On average, each U.S. household spent just over $500 on pets. This amounts to about 1 percent of total spending per year for the average household. ... Expenditures on pets include pet food, pet purchases, supplies and medicine, pet services, and veterinarian services."

Two comparisons leaped to mind when I saw these figures. First, all through last year there were stories about high spending of the 2012 U.S. election campaign. The Federal Election Commissions reports that about $7 billion was spent. But to put the number in the context of dogs and cats, America spent about nine times as much on pet care as it did on choosing all its federally elections in 2012.

Second, the World Bank often uses a poverty line of $1.25/day in consumption to measure deep destitution in developing countries. Nearly one-third of the population of South Asia and nearly half the population of Africa has a consumption level below this line.  Over 365 days in a year, $1.25/day works out to $456.25.  Thus, the average U.S. household spends more on pets than the poverty line for humans in the developing world. And the statistics don't include the fact that pets live rent-free.

In his short essay, Henderson offers some less combustible comparisons. He writes: 

• "In 2011, households spent more on their pets annually than they spent on alcohol ($456), residential landline phone bills ($381), or men and boys clothing ($404).
• "Average household spending on pet food alone was $183 in 2011. This was more than the amount spent on candy ($87), bread ($107), chicken ($124), cereal ($175), or reading materials ($115).
• "Even when spending at restaurants dropped during the recent recession (December 2007–June 2009), spending on pet food stayed constant. (See chart 1.)"

I am deeply aware of all the grim news for the U.S. economy during the last five years. But when the average household is spending $500/year on pets, it's a reminder that America's average standard of living remains quite high.

Global Urbanization and the Governance Challenge

The overall focus of the Global Monitoring Report, jointly published by the World Bank and the IMF, is on how the world is doing in achieving the "Millennium Development Goals" or MDGs. But the annual reports also look at some particular angle or topic more closely, and the 2013 GMR focuses on urbanization and its linkages to economic development. Here's a taste of some main themes:

"Urbanization matters. In the past two decades, developing countries have urbanized rapidly, with the number of people living in urban settlements rising from about 1.5 billion in 1990 to 3.6 billion (more than half of the world’s population) in 2011. ... Nearly 50 percent of the population in developing countries was urban in 2011, compared with less than 30 percent in the 1980s. Urban dwellers are expected to double between 2000 and 2030, from 2 billion to 4 billion people, and the number of

Chinese urban dwellers will increase from more than 622 million today to over 1 billion in 2030. This trend is not unique to developing countries—today’s high-income countries underwent the same transformation in the 20th century. In fact, virtually no country has graduated to a high-income status without urbanizing, and urbanization rates above 70 percent are typically found in high-income

countries."

Overall, the report emphasizes that the global shift to urbanization works together with many development goals.

"Cities and towns are hubs of prosperity—more than 80 percent of global economic activity is produced in cities by just over half of the world’s population. Economic agglomeration increases productivity, which in turn attracts more firms and creates better-paying jobs. Urbanization provides higher incomes for workers than they would earn on a farm, and it generates further opportunities to move up the income ladder. Between 1990 and 2008, rural poverty rates were, without exception, higher than urban poverty rates ... 

"Location remains important at all stages of development, but it matters less in rich countries than in poor ones. Estimates from more than 100 Living Standard Surveys indicate that households in the most prosperous areas of developing countries such as Brazil, Bulgaria, Ghana, Indonesia, Morocco, and Sri Lanka have an average consumption almost 75 percent higher than that of similar households in the lagging areas of these countries. In comparison, the disparity is less than 25 percent in developed countries such as Canada, Japan, and the United States."

The gains from urbanization are not just in terms of income, but also in terms of other development goals like access to clean water, education, and health care.

 "For example, on average, the cost of providing piped water is $0.70–$0.80 per cubic meter in urban areas compared with $2 in sparsely populated areas. South Asia and Sub-Saharan Africa have the largest rural-urban disparities in all service delivery indicators. The poor often pay the highest price for the water they consume while having the lowest consumption levels. For example, in Niger, the average price per cubic meter of water is CFAF 182 for piped water from a network, CFAF 534 from a public fountain, and CFAF 926 from a vendor. And poor access to basic infrastructure disproportionately affects rural women, because they perform most of the domestic chores and

often walk long distances to reach clean water. ...

"In 2010, 96 percent of the urban population but 81 percent of the rural population in developing countries had access to safe drinking water. Disparities in access to basic sanitation were greater: 80 percent of urban residents but only 50 percent of rural residents had access to a toilet. Schooling and health care can also be delivered with economies of scale in dense environments, close to where people actually live."

But of course, the wave of urbanization is also generating urban slums, which are different than rural poverty,  but pose difficult challenges of their own.

"Slums are the urban face of poverty and emerge when cities are unable to meet the demand for basic services and to supply the expected jobs. A likely 1 billion people live in urban slums in developing countries, and their numbers are projected to grow by nearly 500 million between now and 2020. Slums are growing the fastest in Sub-Saharan Africa, southeastern Asia, and western Asia. Currently, 62 percent of Africa’s urban population lives in slums. ...Those in slums lack ownership of property, or even  clearly legal rentals; poor services of many kinds; informal employment only, lack of access to credit and services."

 The issue of slums is in some ways a governance challenge: not just how to provide services in the present to slum-dwellers, but how to establish an appropriate institutional and physical infrastructure.

"Urbanization is largely a natural process, driven by the opportunities cities offer. Unregulated markets are unlikely to get densities right, however, and spontaneous development of cities can create negative side effects such as congestion or, alternatively, excessive sprawl. The consequences are pollution and inefficiencies. Without coordinated actions, cities will lack the proper investments to benefit from positive externalities generated by increased density. Higher-quality construction material and more sophisticated buildings are required to support greater densities, but if these higher

costs must be fully internalized by firms and households, underinvestment is the result. In addition, complementary physical infrastructure is critical: roads, drainage, street lighting, electricity, water, and sewerage, together with policing, waste disposal, and health care. While a market-driven process could possibly gradually increase densities through shifting land values over time, the long-lived and lumpy nature of urban investment often inhibits such a process. A city’s physical structures, once established, may remain in place for more than 150 years....  Under current trends, the expected increases in the urban population in the developing world will be accompanied

by a tripling in the built-up area of cities, from 200,000 to 600,000 square kilometers."

The challenge of thinking about how to address urban slums cannot be overstated. The slums already involve 1 billion people, a total that will grow by over 50% in the next decade. The built-up area of cities in the developing world is likely to triple. And major decisions about physical structure can have a life expectancy of more than a century. There is a delicate balance between needing an overall master plan and needing a lot of a flexibility for evolution and change over time. Even after deciding what to do, financing poses challenges of its own: in particular, how can developing countries establish ways for that poor people  can afford what they need, but also pay what they can afford. Then actually getting projects built is often quite difficult, too.  Urban areas will differ, of course, in their locations and needs. But there is a great need for rules of thumb, and ideas about best practices, that can offer some guidance for the urban developments that lie ahead.

A Defense of the Financial Sector

The financial sector needs some defenders, and John H. Cochrane steps forward with a bracing essay,
"Finance: Function Matters, Not Size," in a symposium in the Spring 2013 issue of the Journal of Economic Perspectives.  (Full disclosure: I've worked as Managing Editor of the JEP since 1987.) Here, I'll list some of the main points that I took away from Cochrane's essay in boldface type, with quotations from the article following.

Economists have been arguing for a half-century that active portfolio management isn't worth the fees paid for it (for example, see my post from yesterday). But when high-fee active portfolio management has persisted for decades in the face of such criticism, perhaps it's the critics who should be wondering if they are correct. 

"High-fee active management and underlying active trading have been deplored by academic finance for a generation. ... It seems the average investor should save 60 basis points a year and just buy a passive index such as Vanguard’s Total Stock Market Portfolio. It seems that the stock pickers should do something more productive, like drive cabs. Active management and its fees seem like a total private, and social, waste. Yet this hallowed view—and its antithesis—do not completely make sense. After all, active management and fees have survived 40 years of efficient-market disdain. Economists who would dismiss “people are stupid” as an “explanation” for a pricing anomaly that lasts 40 years surely cannot use the same “explanation” for the persistence of active management."

There are lots of inefficiencies in financial markets that can be exploited, at least for a time, to make profits.

"But the last 20 years of finance research is as clear as empirical research in economics can be: There is alpha relative to the market portfolio—there are strategies that deliver average returns larger than the covariation of their returns with the market portfolio justifies—lots of it, and all over the place. ... Examples of such strategies include value (stocks with low market value relative to accounting book value), momentum (stocks that have risen in the previous year), stocks of companies that repurchase shares, stocks of companies with accounting measures of high expected earnings, and stocks with low betas. The “carry trade” in maturities, currencies and, credit—buy high-yield securities, sell low-yield securities—and writing options, especially the “disaster insurance” of out-of-the-money put options, all generate alpha. Expected returns on the market and most of the anomaly strategies vary predictably over time, implying profitable dynamic trading strategies."

Highly sophisticated investors pay for active management of their financial assets, and apparently believe they are getting a good deal.  

"Delegating active management and paying large fees is common and increasing among large, completely unconstrained, and very sophisticated investors. For example, the Harvard endowment was in 2012 about two-thirds externally managed by fee investors and was 30 percent invested in “private equity” and “absolute return,” largely meaning hedge funds. The University of Chicago endowment is similarly invested  in private equity and “absolute return.” Apparently, whatever qualms some of its curmudgeonly faculty express about alphas, fees, and active management are not shared by the endowment. ... Why have these decision procedures become standard practice? Vague reference to “agency problems” and “naiveté” seem unpersuasive. Harvard’s endowment was overseen by a high-powered board, including its president Larry Summers, possibly the least naive investor on the planet. The picture that Summers and his board, or the high-powered talent on Chicago’s Investment Committee are simply too naive to demand passive investing, or that they really want the endowments to be invested in the Vanguard total market index, but some “agency problem” with the managers they hire and fire with alacrity prevents that outcome from happening, simply does not wash."

The existence of financial bubbles suggests that markets are inefficient, too. But many of those who are most insistent that financial markets are inefficient often shy away from the logical implication that if the market is inefficient, it might benefit from additional trading. 

"The common complaints “the financial crisis proves markets aren’t efficient,” or that tech and mortgages represented “bubbles,” are at heart complaints that there was not enough active information-based trading. All a more “efficient” market could have done is to crash sooner, by better expressing the pessimist’s views. ... If information is not incorporated into market prices and to such an extent that simple strategies with big alphas can be published in the Journal of Finance, there are not enough arbitrageurs. If asset prices fall in “fire sales,” only to rebound later, there are not enough buyers following the fire trucks. If credit constraints are impeding the flow of capital, there is a social benefit to loosening those constraints."

Do we care about the size of the financial sector or the instability of the financial sector? (And no, they aren't the same thing.)

"The increase in fees for residential loan origination is easily digested as the response to an increase in demand. The increase in housing demand may indeed not have been “socially optimal” (!). There are plenty of government policies and perhaps a few market dislocations to blame. But it doesn’t make much sense to criticize growth in the financial industry for responding to this increase in demand, whatever its source, or for passing along the subsidized credit—which was and remains the government’s explicit intention to increase—with the customary fee. ... There was a lot of financial innovation in mortgage-backed securities, some of which notoriously exploded. But here again, whether we spend a bit of GDP filling out forms or paying fees is clearly the least of the social benefit and cost questions. The “shadow banking” system was prone to a textbook systemic run, which happened. This fragility, not the size or fraction of GDP, is the important issue."

We don't really understand the process of price discovery in financial markets, and as a result, passive investing may be less intuitively attractive on a second glance.

"The fact staring us in the face is that “price discovery,” the process by which information becomes embedded in market prices, uses a lot of trading volume, and a lot of time, effort, and resources. And we are only beginning to understand it.... [P]erhaps we should work just a little harder before dismissing the hundreds of years of trading activity, and the entire existence of the New York Stock Exchange, Chicago Mercantile Exchange, and other markets, as monuments to human folly, or before advocating regulations such as transactions taxes —the perennial favorite answer in search of a question—to reduce trading volume whose size, function, and operation we do not understand. Are we sure that they should not be transactions subsidies? And before we deplore, it’s worth remembering just how crazy passive indexing sounds to any market participant. “What,” they might respond, “would you walk in to a wine store and say ‘I can’t tell good from bad, and the arbitrageurs are out in force. I sure won’t pay you 1 percent for recommendations. Just give me one of everything’?”"

The important aspects of the financial sector that we don't understand are a good basis for research, but in the real world of political economy, they could well be a bad basis for additional regulation.

"Surveying the current economic literature on these issues, it is certain that we
do not very well understand the price-discovery and trading mechanism, nor the
economic forces that allowed high-fee active management to survive so long.
Unless we adopt the arrogant view that what we don’t understand must be bad,
it is clearly far too early to make pronouncements such as “There is likely too much
high-cost, active asset management,” or “Society would be better off if the cost of
this management could be reduced.” Such statements are not supported by theory
or evidence. Nor is their not-so-subtle implication that resources devoted to greater
regulation—by politicians and regulators no less naive than current investors, no
less behaviorally-biased, armed with no better understanding than academic economists,
and with much larger agency problems and institutional constraints—will
improve matters."

Cochrane's paper is part of a five-paper symposium on "The Growth of the Financial Sector" in the Spring 2013 issue of the Journal of Economic Perspectives.

Economies of Scale in Asset Management: Who Benefits?

The total assets managed by domestic equity funds rose from $26 billion in 1980 to $3.5 trillion in 2010. Would you expect the expenses charged by such funds to rise in proportion to the amount that they manage? Or by less?

Burton G. Malkiel argues in "Asset Management Fees and the Growth of Finance," in the Spring 2013 issue of my own Journal of Economic Perspectives,  that there should be considerable economies of scale in managing a stock portfolio. (Like all articles in JEP back to the first issue in 1987, it is freely available on-line compliments of the American Economic Association.) Malkiel writes:

"There should be substantial economies of scale in asset management. It is no more costly to place an order for 20,000 shares of a particular stock than it is to order 10,000 shares. Brokerage commissions (which are usually set in a flat dollar amount per transaction, at least within broad ranges of transaction size) are likely to be similar for each purchase ticket, as are the “custodial fees” paid to the bank that holds the securities that are owned. The same annual report and similar filings  to the Securities and Exchange Commission are required whether the investment fund has $100 million in assets or $500 million. The due diligence required for the investment manager is no different for a large mutual fund than it is for a small one. Modern technology has fully automated such tasks as dividend collection, tax reporting, and client statements."

Malkiel also cites more rigorous academic studies that find economies of scale. But despite the more than 100-fold increase in share of assets under management for these funds, the average amount paid as expenses has not declined in three decades. Here's the table, showing an expense ratio of 66 basis points of assets under management in 1980, but 69.2 basis points as a share of assets under management in 2010.

As Malkiel writes: "Surely, there had to be enormous economies of scale that could have been passed on to consumers, resulting in a lower cost of management as a percentage of total assets. But we will see below that the scale economies in asset management appear to have been entirely captured by
the asset managers. The same finding appears to hold for asset managers who cater to institutional investors."

The table shows some other interesting factors. Equity funds can either be "actively managed," by those trying to anticipate where the market is headed, or "passively managed," by index funds that seek only to replicate what happens in the market. In 1980, 99.7% of all stock market funds were actively managed; by 2010, 71% were actively managed. 

The expense ratios for passively managed funds are often very low, at 7 basis points or less. The expense ratios for actively managed funds alone (shown in the second column of the table) have actually risen from 66 basis points back in 1980 to over 90 basis points as a share of assets in the last decade or so. And remember, this is during a period when economies of scale should have been a force for driving down expenses as a share of assets!


Back in 1973, Burton Malkiel published the first edition of his classic A Random Walk Down Wall Street.  (I think the 9th edition came out a couple of years ago.) The book offers a readable and persuasive statement of the argument that stock prices are based on past information, and that they will rise and fall based on new information. Because new information is, by definition, not predictable (or else it would be part of past information!), stock prices will move up and down unpredictably. Malkiel has been making the case for 40 years that while actively managed equity funds  charge higher fees than passively managed funds, they do not on average have higher returns.  In this essay, he writes:

"Clearly, one needs some active management to ensure that information is properly reflected in securities prices. Those professionals who act to exploit any differential—however small—between price and estimated value deserve to be compensated for their efforts. But it appears that the number of active managers and the costs they impose far exceed what is required to make our stock markets reasonably efficient, in the sense that no clear arbitrage opportunities remain unexploited. Worldwide, vast numbers of highly trained independent experts are expressing estimates of value each day. Outperforming the consensus of hundreds of thousands of professionals at the world’s major financial institutions is next to impossible, as it has been for decades. ... The major inefficiency in financial markets today involves the market for investment advice, and poses the question of why investors continue to pay fees for asset management services that are so high."

I'm sure there are people and institutions that can benefit from sophisticated investment advice that seek to hedge the specific risks they face while leaping to exploit the occasional profit opportunities provided by temporary anomalies in financial markets. But most average investors in actively managed funds are not following this pattern. They are following either their own gut reactions, or the gut reactions of an active portfolio manager, about what is likely to rise and fall. In doing so, they are paying much higher fees over what an index fund would have cost. Malkiel cites one study that found if the average mutual fund investor in actively managed funds had just bought and held a passive index fund from 2000 to 2011, rather than trying to chase every trend, that average investor would have increased return on investment by almost 2 percentage points per year--a gain of more than 20% over the decade.

Why Did the U.S. Financial Sector Grow?

It's widely known that the U.S. financial sector has grown substantially in recent years. But by how much? And in what specific areas? Robin Greenwood and David Scharfstein offer a useful breakdown in "The Growth of Finance," which appears in the most recent (Spring 2013) issue of my own Journal of Economic Perspectives. Like all JEP papers from the most recent back to the first issue in 1987, it is freely available on-line compliments of the American Economic Association. Greenwood and Scharfstein write at the start: "During the last 30 years, the financial services sector has grown enormously. This growth is apparent whether one measures the financial sector by its share of GDP, by the quantity of financial assets, by employment, or by average wages. At its peak in 2006, the financial services sector contributed 8.3 percent to US GDP, compared to 4.9 percent in 1980 and 2.8 percent in 1950."

But what is actually meant by "the finance sector"?  Here's a useful figure dividing the sector into three parts: securities, credit intermediation, and insurance.

In their discussion, they set aside the insurance part of the financial services sector. Of course, there are important issues in health insurance, liability insurance, and other types of insurance. But when people argue that "the financial sector" is too big, or that an over-expansion of the financial sector helped to bring on the Great Recession, they aren't referring to standard insurance markets. Greenwood and Scharfstein summarize the other two main sectors in this way:

"The securities subsector ... includes the activities typically associated with investment banks (such as Goldman Sachs) and asset management firms (such as Fidelity). These activities include securities trading and market making, securities underwriting, and asset management for individual and institutional investors. The credit intermediation industry performs the activities typically associated with traditional banking—lending to consumers and corporations, deposit taking, and processing financial transactions."

The authors turn over the available evidence on what happens within these sectors over time (and no, this sort of data is not easily available), and argue (citations omitted here and throughout):

"Our main finding is that much of the growth of finance is associated with two activities: asset management and the provision of household credit. The value of financial assets under professional management grew dramatically, with the total fees charged to manage these assets growing at approximately the same pace. A large part of this growth came from the increase in the value of financial assets, which was itself driven largely by an increase in stock market valuations (such as the price/earnings multiples). There was also enormous growth in household credit, from 48 percent of GDP in 1980 to 99 percent in 2007. Most of this growth was in residential mortgages. Consumer debt (auto, credit card, and student loans) also grew, and a significant fraction of mortgage debt took the form of home equity lines used to fund consumption. The increase in household credit contributed to the growth of the financial sector mainly through fees on loan origination, underwriting of asset-backed securities, trading and management of fixed income products, and derivatives trading."

Their conclusions on these points are balanced, but lean toward the view that even if much of the growth in financial services has been productive, it went too far on the margin. They write:

"Thus, any assessment of whether and in what ways society benefited from the growth of the financial sector depends in large part on an evaluation of professional asset management and the increase in household credit. In our view, the professionalization of asset management brought signififi cant benefits. The main benefit was that it facilitated an increase in financial market participation and diversification, which likely lowered the cost of capital to corporations. Young firms benefited in particular, both because they are more reliant on external financing and because their value depends more on the cost of capital. At the same time, the cost of professional asset management has been persistently high. While the high price encourages more active asset management, it may not result in the kind of active asset management that leads to more informative securities prices or better monitoring of management. It also generates economic rents that could draw more resources to the industry than is socially desirable."

"While greater access to credit has arguably improved the ability of households to smooth consumption, it has also made it easier for many households to overinvest in housing and consume in excess of sustainable levels. This increase in credit was facilitated by the growth of “shadow banking,” whereby many different types of nonbank financial entities performed some of the essential functions of traditional banking, but in a less-stable way. The financial crisis that erupted late in 2007 and proved so costly to the economy was largely a crisis in shadow banking."

The Spring issue of the JEP actually includes four other papers with varying perspectives on the growth of the financial sector. In the next couple of days, I'll post about some of these very divergent views.

But as a prelude, I'll point out that most of the time, when economic activity grows in a certain area, those of us who believe in economic prosperity tend to view that growth as a good thing. If the U.S. car industry or computer industry racked up large sales, that would be viewed in a positive light. Clearly, many people feel differently about the financial sector. But is that negative reaction just a manifestation of the long-standing generalized prejudice against finance? After all, I'm delighted that I can put my retirement savings into a no-load mutual fund, and that I don't have to try to construct and manage such a fund on my own. I'm delighted when it's easy for me to get a mortgage.

It seems undeniable to me that excesses in the financial sector played a large role in the run-up to the Great Recession. But maybe the problem isn't the size of the financial sector, but rather its instability. After all, many of the proposals for a higher level of regulation will impose higher costs that in turn will tend to make the financial sector larger, not smaller.