How Did the Original J.P. Morgan Do It?

An NYU professor figures was cheaper and more efficient in 1910 than in 2012
JPMorgan Chase headquarters in New York Photograph by Mark Lennihan/AP Photo

The United States emerged as the world’s leading industrial nation between the Civil War and the First World War. The towering heights of American capital were dominated by a handful of investment banks, with the most prestigious firm being J.P. Morgan & Co. Despite their considerable power, the investment banks were small. Morgan had a baker’s dozen of partners with at most three clerks per partner in the early 1900s, according to J. Bradford De Long, economist at the University of California, Berkeley. Even as late as the 1960s, Wall Street comprised some 20 partnerships with an average of 500 employees and an aggregate capital base of less than $100 million, estimates Roy Smith, former Goldman Sachs partner and economic historian at New York University Stern School of Business.

Today, Wall Street companies are global behemoths with hundreds of thousands of employees worldwide. The three best-known names—Goldman Sachs, Morgan Stanley, and JPMorgan Chase—sport a combined market capitalization of some $222 billion. Over the past three decades, finance transformed itself into a growth business. The downside was painfully revealed during the global credit crunch of 2008. And an ugly reminder of the risks inherent trading just came when JPMorgan Chase announced it had lost $2.3 billion on a derivative-based profit-making strategy gone bad.

Calls are mounting in Washington for a tougher reading of the so-called Volcker Rule, a measure designed to limit system-wide downside risk by restricting deposit-taking institutions from trading for their own account. Problem is, the issue is bogged down in a murky debate over how to define the difference between hedging a bank’s exposure (prudent) and speculating on it (gambling). Hedging in theory reduces taxpayer risk with too-big-to-fail institutions; speculating increases it. Stronger measures seem called-for, such as breaking up banks by bringing back the Glass-Steagall Act of 1933—which long separated commercial and investment banking—as well as higher capital requirements.

Here’s the thing: Odds are strong that financial regulations will neither hurt the economy nor dampen innovation—two traditional cautions. The reason is that the modern finance industry has become a bloated, inefficient sector of the economy. Put it this way: “The finance industry of 1900 was just as able as the finance industry of 2010 to produce loans, bonds, and stocks, and it was certainly doing it more cheaply,” says Thomas Phillippon, finance economist at NYU’s Stern School of Business at New York University. Taken altogether, he adds, the “finance industry’s share of [gross domestic product] is about 2 percentage points higher than it needs to be, and this would represent an annual misallocation of resources of about $280 billion for the U.S. alone.”

Say what? Surely, the market is more efficient in the era of Jamie Dimon than when J.P. Morgan ruled Wall Street. Morgan partners were hand-writing documents at desks in rooms that were large and open to facilitate communications. Messenger boys rushed about lower Manhattan with buy-and-sell orders. The telegraph, the ticker, and the telephone took the capital markets industry from a local business to a national one, but the speed of those communications pales next to that of the Internet Age. Modern financiers have invested trillions in powerful supercomputers, sophisticated software, and  quicksilver global communications networks. The most powerful illustration of the potent combination of technology and brains is the $648 trillion notional value for financial derivatives at the end of 2011, according to the Bank for International Settlements. But as the late economist John Kenneth Galbraith once remarked: “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.” He could have added “a more costly version,” too.

That’s what Phillippon’s economic calculations suggest. The role of finance in the economy includes matching savers with borrowers, pooling risks, and producing information through price changes. Total compensation for these services is the sum of profits, wages, and bonuses. Compensation reached an all-time high of around 9 percent of gross domestic product in 2010, up from up from 5 percent in 1980 and 4 percent in 1900. The economic value of finance is debt issuance, mutual-fund money management, financial derivatives, and the like. (Phillippon’s calculations try to exclude real estate from his 130-year data series; he also focuses on non-war related GDP.) Phillippon can then estimate the unit cost of the financial middleman, which was 1.3 percent of all financial assets percent in the early 1900s and amounts to some 2.3 percent currently, with much of the rise having occurred since the 1970s.

In other words, despite the information-technology revolution of the past 40 years, the cost of finance is greater. The experience of many other industries, such as retail, is very different. Take Wal-Mart: The retailing juggernaut met its promise of low everyday prices by embracing information technologies. According to McKinsey & Co., Wal-Mart invested early and aggressively in computers to track inventory in 1969, adopted bar codes in 1980, and installed wireless scanning guns in the late 1980s. These investments reduced inventory costs significantly, reaped savings, and boosted the company’s labor productivity.

What happened in finance? It seems that much technological innovation dramatically hiked trading. The level of trading activity as a percentage of GDP is three times larger than at any time in history. Foreign-exchange trading volumes are more than 200 times greater than in 1977. Trading is a major revenue generator for the largest banks. Yet Phillippon says there’s little evidence that market prices are more informative than before or that risk sharing has improved. “We should all treat financial innovation with skepticism,” notes James Montier, a member of the asset allocation team at GMO, the Boston-based money manager. “All too often, financial innovation is just thinly veiled leverage.”

This isn’t to say there hasn’t been financial innovation in recent decades. The advent of the Standard & Poor’s 500-stock index in the mutual fund sector opened up low-cost, economically savvy investing for individuals. The ATM liberated checking accounts from bank branch hours. The rise of angel investing organizations created new capital-raising opportunities for entrepreneurs. Still, it’s striking how little financial innovation has benefited the economy and how much it has cost in recent decades. Perhaps we would all gain from a smaller financial system that played a supporting role to American business, rather than dominating it.

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