05.15.09
WSJ Out of Touch?
There was a terrific graph in the Wall Street Journal yesterday (pC1). It showed pay in the financial sector normalized against pay in all other non-farm endeavors over the last century. A hundred years ago the ratio was around 1.5. For every dollar people in other non-farm jobs earned, people in the financial sector earned a dollar and a half. This ratio climbed until the early 1930’s. Then it levelled off around 1.6. In 1940 it fell precipitously to 1.2. It continued to drift downward until 1980 when it was almost at parity. Since 1980 it has risen steeply. In 1998 it exceeded 1.6. And recently it has exceeded 1.7 - the highest level in at least a century. The financial industry has been seeing outsized pay for almost the last three decades.
What is one to think of this? On the one hand, we note that with the expansion of America’s middle classes, with their growing ability to save and invest, has come a dramatic increase in the amount of capital seeking good management. Even in the ninteen fifties and sixties, investment in the capital markets was seen as an endeavor of rich people. But by the end of the 1980’s everyone with a good job was salting money away in the capital markets. Assuming some modest returns to scale and inprovements in productivity due to improving IT systems, it seems reasonable to assume that pay in the sector would increase. It would be in everyone’s best interest for it to do so, so long as the financial system grew more efficient at allocating a growing pool of resources.
A second factor in assessing the rise in financial sector pay is the argument that the financial sector works by allocating resources to the most efficient means of production. A healthy financial sector does this better than an ailing one. And it is definitely worth a lot of money to get this allocation system working efficiently. This is a reasonable and supportable argument. And to the extent that rising pay in the finiancial sector has led to more efficient means of production - in excess of the premiums to pay within financial sector itself - we are all better off for it.
We are not prepared to argue whether these conditions are strictly satisfied. The market is not always completely efficient. That, however, is the topic of another discussion.
Moving beyond that issue we see two monumental problems that attach to the situation of stratospheric pay levels within the financial industry: Transparency and Opportunity Cost.
There is a lot of talk about transparency. Not coincidentally, the same WSJ page features and article about regulations pertaining to derivatives and other esoteric financial instruments.
There ought to be discussions about this, because when wealth is transferrred to the financial system in excess of the value added by that system, we all become impoverished. Lack of transparency is the magic that makes such a transfer possible. Madoff’s whole scheme worked because of lack of transparency. He claimed to have magical powers. And people believed him.
Lack of transparency leads to chicanery: It is what makes that transfer seem desirable when it is actually not so. There are a thousand highly paid political operatives working on resoring transparency. And if capitalism is to function correctly, they damn well better take a good crack at it. In light of this work ther is a glimmer of hope that it will be fixed by good legislation. ( In Journal-Talk, Regulation)
When all the processes in the financial market are open, frank, truthful, unbiased, unpuffed, unwrapped, and in plain view of all interested parties, there is some small hope that the market can approach efficiency. The size of the distortions tends to be limited, at least. When it is otherwise - when the distortions become a huge part of the system, the financial industry will swallow up great gobs of capital, pay it to its operatives, and weath-making enterprises - companies that manufacture and distribute goods and services that add real value to peoples’ lives - will quickly starve for lack of capital. That is the fast-track to serfdom.
The second problem with stratospheric pay in finance is opportunity cost. Every economic activity requires an input of talent. When all talent flees any activity it is usually not long before the activity stands on shaky ground. It is not long before it begins to crumble. When I was leaving college, for instance, steel producing companies were losing money on US operations. There were lots of reasons. Part of it was that factory floor pay in the US was an order of magnitude higher than it was in the far east. And unskilled labor in the far east was more productive. So it made sense to invest there rather than here. In any case, steel companies, when they offered jobs to degreed engineering graduates, paid the worst. So on average, they probably also got the worst. This drove them into a kind of inevitable downward spiral. There still exist a few specialty steel makers. But most of the industry is located offshore.
Every manufacturing industry in the US competes for talent with the financial industry. It does so for engineering, business, and finance professionals. If the financial industry is paying more than any manufacturing industry, where will people with the best talent go?
There is absolutely no question that finance needs good people to allocate resources among businesses. But what if all businesses are handicapped by their inability to hire the best talent? The process of efficient allocation no longer produces the best economic result. I am told by my wife who graduated from Columbia Business School in the late 1980’s that almost all the best people specialized in finance. They planned to work on Wall Street because that’s where they could make the most money. At that point in time the ratio between finance and other non-farm pay was 1.2. In other words, that level of pay proved no hinderence to the financial system in terms of attracting talent. The additional fifty cents on the dollar amounts to excess profit drained from the capital pool that could be used to rebuild manufacturing in the US or rebuild a crumbling infrastructure.
The readers of WSJ tend to be more closely connected with the financial system than readers of any othe publication, so it is not unexpected that WSJ should advocate for their interests. The readers of the WSJ will likely be people who view with suspicion and animosity any regulation that threatens to derail the gravy train. Maybe, though, that is precisely what needs to happen.