For at least a quarter of a century, the financial sector has grown far more rapidly than the economy as a whole, both in developed and in most developing countries. The ratio of total financial assets (stocks, bonds and bank deposits) to GDP in the UK was about 100 percent in 1980; by 2006 it had risen to around 440 percent. In China, financial assets went from being virtually nonexistent to more than 300 percent of GDP during this period.
As the size of the financial industry grew, so too did its profitability. The share of total profits of companies in the US represented by financial firms rocketed from 10 percent in 1980 to 40 percent in 2006. Against that background, it is not surprising that pay in the financial sector soared. The City of London, lower Manhattan and a few other centers became money machines that made investment bankers, hedge fund managers and private equity folk immoderately wealthy. University leaders like me spent much of our time persuading them to recycle a portion of their gains to their old schools.
For the last two years, things have been different. Many financial firms have shrunk their balance sheets dramatically and, of course, some have gone out of business altogether. Leverage is down sharply. Investment banks with leverage of more than 30 times their capital in early 2007 are now down to little more than 10 times. Trading volumes are down, as is bank lending, and there have been major layoffs in financial centers around the globe.
Is this a short-term phenomenon and will we see an early return to rapid financial-sector growth as soon as the world economy recovers?
Already the market is full of rumors that guaranteed bonuses are returning, that hedge funds are making double-digit returns and that activity is reviving in the private equity market. Are these harbingers of a robust recovery for the financial sector, or just urban myths?
There is no certain answer to that question, but perhaps economic history can offer some clues.
A recent analysis by the Bank of England’s Andy Haldane of long-term returns on UK financial sector equities suggests that the last 25 years have been very unusual.
Suppose you had placed a long-term bet on financial equities in 1900, along with a short bet on general equities — in effect a gamble on whether the UK financial sector would outperform the market. For the first 85 years, this would have been a very uninteresting gamble, generating an average return of only about 2 percent a year.
However, the period from 1986 to 2006 was radically different. During those two decades, your annual average return would have been more than 16 percent. As Haldane puts it: “Banking became the goose laying the golden eggs.”
Indeed, there is no period in recent UK financial history that bears any comparison to those jamboree decades.
If you had unwound your bet three years ago, you would now be sitting pretty — as long as you had gone into cash, of course — because the period since 2006 has undone most of these gains. So if you had held your bank stocks up to the end of last year, over 110 years your investment would have yielded an annual average return of less than 3 percent, still broadly a breakeven strategy.
Why was this 20-year experience so unusual, with returns so much higher than at any time in the last century?