Are Wall Street Profits Fundamentally Based on Consumer Laziness?

Brad DeLong:

It used to be that we collectively paid Wall Street 1% per year of asset value–which was then some 3 years’ worth of GDP–to manage our investment and payments systems. Now we pay it more like 2% per year of asset value, which is now some 4 years’ worth of GDP.

He is responding to a post by Noah Smith that, when I click on it, turns out to be a response to me. My question was simple: finance is a very competitive industry, so how has it stayed so astronomically profitable for so long? Smith suggests that part of the answer is lending to households, but another part is asset management fees:

Asset-management fees are middleman costs that all kinds of players in the finance industry charge to move money around….The amount of wealth in the U.S. economy has soared since 1980 — just think of the rises in the housing and stock markets over that time — meaning that the middlemen in the finance industry have been taking their percentage fees out of a much larger pool of assets.

….But why have profits from these middleman fees stayed so high? Why haven’t asset-management charges gone down amid competition? In a recent post, I suggested one answer: people might just be ignoring them. Percentage fees sound tiny — 1 percent or 2 percent a year. But because that slice is taken off every year, it adds up to truly astronomical amounts. So if people are just ignoring what middlemen skim off the top, because each fee seems small, investors could be handing significant fractions of the country’s GDP to the financial sector out of sheer carelessness. That would certainly keep profits high; if many investors pay no attention to what they’re being charged, more competition can’t push down those fees.

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.

James Kwak has more here, basically suggesting that lots of people pay high fees for actively-managed funds deliberately. They figure that the higher price means better performance, just as a higher price usually means better performance in most areas of the consumer economy.

If Smith and Kwak are right, it means the enormous profitability of the financial system is based primarily on products sold to consumers (mutual funds, home loans), not to services offered to the rich or to the rest of the industry. Is this true? To find out, someone would have to break out industry profitability by product line (so to speak) and figure out where most of the money is coming from. Has anyone ever done that?