So a combination of rising asset values and unchanging management fees can explain a large part of both finance’s growth and its continued profitability.
The other big piece of finance’s growth has been household credit, with a lot of it going for big ticket items like houses and cars, U.S. households have been borrowing more and more since 1980 -- as Greenwood and Scharfstein report, household credit soared from 48 percent of GDP in 1980 to 99 percent in 2007. Mortgages were by far the biggest piece of this. When people borrow more, the finance industry makes money by collecting interest, and also by charging middleman fees on lending transactions.
Why did people borrow so much more? One big reason was the growth of securitization, which allowed the finance industry to convince itself that it was lending money safely to people it never would have extended credit to before. That, of course, had disastrous consequences in 2008, but securitization remains a big part of the lending industry. Also, Greenwood and Scharfstein suggest that people might have just decided to borrow more -- homeownership and/or house flipping might simply have gotten more popular, allowing the finance industry to reap a gigantic windfall.
But that leaves the question of why lending remained profitable. Why didn’t new lenders enter the market and push interest rates and middleman fees down? Well, rates certainly fell, but not enough to cancel out the growth in the industry’s size. One possibility is that lending has significant economies of scale -- that big banks will always be able to lend money more cheaply, at higher volumes, than small ones. That would tend to preserve profit margins as the size of the lending increased.
So I would say that we have a partial answer to Drum’s big question. The finance industry grew in size because U.S. asset markets rose in value, and people borrowed more. As to why the finance industry retained its enormous profit margins -- or why it was so profitable even before 1980 -- this isn't as clear. Old explanations -- economies of scale and other barriers to entry -- are a possibility. Behavioral effects, like simple ignorance of middleman fees, are another. But the extreme profitability of finance is not yet well-understood. This is a puzzle for economists to work on.
Noah Smith is an assistant professor of finance at Stony Brook University and a freelance writer for a number of finance and business publications.