The Baumol effect (or “disease”) suggests that the parts of the economy with the slowest productivity growth are likely to grow the fastest. Howzat, you ask? Well, say productivity grows in widget-making but not in article-writing. The cost of writing articles will rise, because the only way you'll get RA's to write them for you necessary research assistance is to pay higher wages. Otherwise they'll all go away and make widgets. So (if you make a bunch of other assumptions that I won’t get into here) the amount of money spent on article-writing will rise.
Simon Johnson recently published a disconcerting chart that showed finance profits rising dramatically as a % of all corporate profits, starting in the 1980s and peaking in 2006 at a rather mind-boggling 41 percent. I’m honestly not sure how to think about that, so I went to the BEA and downloaded data on the financial industry’s share of value-added and employment. That produced this chart, of data between 1948 and 2007:
Finance’s share of GDP grows monotonically over the last sixty years. Employment in finance, however, grows about as fast as value-added until the 1980s, when it starts to accelerate, and the 1990s, when it takes off.
There are three ways to think about this, it seems. One is that productivity within the financial sector grew dramatically in the 1990s. “Financial innovation” and the like, whatever that is.
The second is that the financial industry became much less competitive in the 1990s. The bankers managed to extract rents from the rest of society and increase their share of the pie without producing any equivalent benefit. Some of those rents went to finance employees, while others went to the firms’ owners and creditors, but is was all about the rents.
The third is that the relative productivity of the financial industry collapsed during the 1990s. Capital and skilled labor could earn a lot more elsewhere, so the financiers needed to offer them more in order to keep their services. Some of the higher cost per financial-service went to capital and some to labor, but the growth of the sector was due to Baumol’s disease.
The $64,000 — $64 billion, $6.4 trillion, whatever — question is: how can you distinguish between these three different hypotheses?
And the meta-question: does knowing which of the three best fits the facts change the analysis of the financial collapse? That is, does the question matter?
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