The Real Problem With High Wall Street Pay
Sometimes an interesting paper doesn’t do much more than provide empirical confirmation of what basic theory would predict. For example, Thomas Philippon and Ariell Reshef have a paper (PDF) illustrating the point that the relative wage in the financial sector tends to track the relative education level of the personnel:
We use detailed information about wages, education and occupations to shed light on the evolution of the U.S. financial sector over the past century. We uncover a set of new, interrelated stylized facts: financial jobs were relatively skill intensive, complex, and highly paid until the 1930s and after the 1980s, but not in the interim period. We investigate the determinants of this evolution and find that financial deregulation and corporate activities linked to IPOs and credit risk increase the demand for skills in financial jobs. Computers and information technology play a more limited role. Our analysis also shows that wages in finance were excessively high around 1930 and from the mid 1990s until 2006. For the recent period we estimate that rents accounted for 30% to 50% of the wage differential between the financial sector and the rest of the private sector.
As Ryan Avent points out, there’s a reasonable case to be made that this is actually the Wall Street compensation issue we should be worried about:
Officials in Washington scrutinising the pay packages of TARP recipients are primarily focused on the incentive effects of those pay structures—whether financial pay packages are inducing financial employees to take excessive risks. But the bigger incentive problem may be—almost certainly is—the drain of talent from other fields, into finance. If there were more evidence that this drain was producing significant net benefits for the economy, than there would be less cause to worry. To an increasing number of people, it looks as though the financial sector is recruiting the nation’s best brains and putting them to work endangering the global economy.
Imagine a world in which being the owner of one of these telephone psychic scam operations discovered that high-skill fake-psychics could produce more earnings than a low-skill fake-psychic. He might start recruiting more people from top schools. And other firms would notice that this one guy moving up the skill chain was producing benefits, and begin doing the same himself. Over time, competition between firms would drive compensation in the psychic sector up and a greater-and-greater share of the high-skill workforce would start draining out of other fields and into psychic work. This would, in turn, seem likely to create a less productive economy over time. Some people would be arguing that the high wages in the psychic sector are, as such, proof that the psychics are generating social value. But nobody looks at the actually existing psychic industry and infers from the fact that psychics are able to earn income that psychics possess real ability to forecast the future. Rather, we recall that as Larry Summers famously argued “there are idiots”.
31 Responses to “The Real Problem With High Wall Street Pay”
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October 15th, 2009 at 11:35 am
This is pretty much what Calvin Trillin was saying the other day.
October 15th, 2009 at 11:47 am
In an sense, escalating pay for financial jobs is an arms race that also happens to have massive negative externalities. The claim that financial firms have to pay as much as they do to attract the top talent only works relative to other financial firms. If everyone paid less, then that would just shift talent away from finance, and we’d have more scientists and entrepreneurs (and lawyers, but, hey, nothing’s perfect).
Why has the escalation happened in finance, but not in, say, law?
October 15th, 2009 at 11:58 am
So the new marketing is: Ok we are asholes, but we are smarter than you, so we deserve all the money. Really? Didnt look very smart what they did to me.
October 15th, 2009 at 12:00 pm
And i agree, there are idiots. One simple way to discover idiots is to see if they got some strange iq obsession paired with some funyn theory about iq distribution. How was that again with Summers? According to him, male economists are smartest and female social scienctest the dumbest academics ….
October 15th, 2009 at 12:03 pm
The question isn’t whether there are idiots, it’s whether we know better. And thinking that we know better is generally idiocy. Which is why we let the psychics do their work, and the Wall Streeters theirs.
I’d think that the “there are idiots” line might be retired by an administration that shovels cash to Chrysler. There’s an example of idiots at every step, from the policymaker to the manufacturer to the line worker to the consumer, and yet the policy is the policy. If the government can’t get that one right–if they didn’t have the courage to refuse to subsidize a business that only an idiot would buy from–how much do we trust them to get the other answers right?
October 15th, 2009 at 12:04 pm
Haruspices also work in this example.
October 15th, 2009 at 12:22 pm
As someone who went to the same schools as these so called “best brains” I really doubt that the idea that they are that smart. I mean we are not talking about whiz kids who started their own successful businesses at age 19, or kids who get into the best phd programs or law schools…
When we are talking about wall street, we are talking about people like you. Mediocre talents who got into elite schools due to them having the family resources growing up to “prep” them for admissions to harvard or what not. Then they spend their careers creating substandard product, whether it be political hackery or crap work in the financial field. The real problem with wall street isn’t the salary structure, it’s that the people who wallstreet recruits have giant egos, great pedigrees, a sheltered and culturally insular outlook and a lack of talent…a deadly combination…
October 15th, 2009 at 12:28 pm
Thomas, amazing how you defend shoveling a relatively paltry sum to Chrysler, but couldn’t care less about the trillion dollars the banking industry recieved.
After-all, they can do their own thing!
October 15th, 2009 at 12:29 pm
These bankers are intelligent. They were mildly above average kids who got a huge boost because they came from a wealthy family. Most of these bankers would be working at Wall-Mart if mommy and daddy had lived in a trailer park.
October 15th, 2009 at 12:40 pm
soullite, how many ways are there to miss the point? It isn’t a trillion dollars, and the smaller total amount for “financial institutions” includes much of the money handed to Chrysler, and the purpose of giving money to banks was to recapitalize them, on the theory (perhaps mistaken) that we need banks, while the theory for why we needed to hand cash over to Chrysler hasn’t been offered up. But put that to one side: What do you think of the bailout? If you oppose it, aren’t you agreeing with me?
And, what’s wrong with working at WalMart?
October 15th, 2009 at 1:11 pm
Money is a zero sum game. If these people get paid too much, others get paid too little. What Matt, DTM, and the rest of the free-market fairy folks want you to believe is that the stratospheric rise in banker income has had absolutely nothing to do with the stagnant and declining wages over the same time period.
Thomas, are you a retard? the extremely low pay. The way Wal-Mart treats it’s employees. The wage theft. The locking of people inside overnight. The cut-backs on hours. The unpaid overtime. Should I go on?
October 15th, 2009 at 1:15 pm
Thomas, I don’t remember any real rational for handing bankers a trillion dollars either. first people like you said it would increase lending. Then you said “haha, this was never going to increase lending”. Then you started making up BS reasons why we couldn’t do anything to break these banks apart, while simultaneously saying they were just too big to fail so we had no choice but to bail them out.
You just hate working people, and resent like hell the idea that they might get anything in this society. thats why you accepted one BS rationale and dismissed another BS rationale.
October 15th, 2009 at 1:16 pm
I think this analysis is wrong (without having read the pdf). I think what the authors of the study wound up tracking was a combination of the changes in how wealthy people percieved their roles in society with how affiliated (and identified with) financial services were to the wealthy itself(not as servants of the wealthy).
The changes reflect the military’s absorbtion and release as an occupation that is acceptable to the wealthy. If this weren’t the case, I think you would have seen much more growth during the latter 60’s and 70’s as revolutionary financial (and sophisticated) products were invented that needed very bright people to understand well. I also think that if you did a graph of certain occupations that required a degree but not too hard, or not easy to judge quality of work, you’ll find the same things–say psychoanalyst or insurance company exec.
However, nothing will be as marked as financial services (or probably military services as well) given all the memes like “masters of the universe”. At best you can get something like a graph of medical occupations that require an M.D. Pleny of suboccupations like radiology are a great way to say that you’re deserving of lots and lots of money. However, most of these occupations (especially in surgery) genuinely require talent. Why do you think the AMA is so resistant to the idea of throwing out incompetent doctors who causes multiple malpractice suits? Lots of socially connected losers who’ve managed to complete degrees despite little ability.
This is not occupations that are sucking talent out of other occupations. It’s more that class is becoming more and more identified with occupation. Caste society! Of course, people who wish to *change* class explicitly will want to go into financial services. But riddle me this, how many Jay Gatsbys with determination and talent do you think there really are?
October 15th, 2009 at 1:17 pm
Why has the escalation happened in finance, but not in, say, law?
It has happened in law. You just haven’t noticed it. Starting package at white-shoe firms is 145k. Upper-year associates run multiple six figures. A good in-house counsel runs into the seven figures.
October 15th, 2009 at 1:22 pm
We are essentially debating a moot topic. The fact of the matter is, we are undergoing a shift in society where there is much more fluidity in talent and decision making, to the extent that major corporate decisions are ceasing to be made in house, and instead made by (much smarter and more talented) people at McKinsey or Goldman. This is coincident with a shift of talent away from business management, to consulting, finance, and corporate law, who gradually will become the real management in a strategic sense.
As decision making flows from inside the firm, to outside agencies, so does talent, and so does money.
October 15th, 2009 at 1:24 pm
In a way, it represents a much more efficient allocation of management talent, as it means that a great deal of frictional costs, of talent being tied to one company despite periodic changes in need for talent, are reduced, and groups of the most competent management talent are quickly allocated where they are most need.
October 15th, 2009 at 1:42 pm
They were mildly above average kids who got a huge boost because they came from a wealthy family.
Do you know what teh CEO of Goldman’s father did for a living?
October 15th, 2009 at 1:45 pm
@15,16: That might be more credible if it were accompanied by some evidence that “management talent” actually adds value.
October 15th, 2009 at 1:46 pm
The real problem with high wall street pay is:
1. Wall Street sucks wealth from the real economy just like a parasite sucks life from its host.
2. Wall Street actually weakens and destroys viable businesses and jobs.
3. Wall Street promotes incorrect understandings of how economies work.
4. Wall Street rewards insider dealing and perversion of democracy.
5. Finally, Wall Street rewards malfeasance and is destroying the USA.
October 15th, 2009 at 1:47 pm
Do you know what teh CEO of Goldman’s father did for a living?
Was he an LOL CAT?
October 15th, 2009 at 1:56 pm
I think the real reason the pay is so high is Wall Stree is populated by people who care how much they make. Now, you might say – “Doesn’t everyone care how much they make?” I would no, most people really don’t care very much.
In my business everyone gets a 2% raise even though, due to the increase in skills and experience, their value on the open market rises much faster than that every year. One would think that after 2-4 years people would switch jobs to take advantage of their increased earning potential – but they don’t.
A friend was laid off (into the worst recession since the great depression) 3 months ago and he starts a new job on Monday – with a 25% raise. He had been unwilling to even look for a new job until he got laid off – why? I guess he was happy making what he was making and didn’t feel the need to try and earn more.
Wall Street is populated by people who care about how much they make and are willing to put pressure on their employers to maximize their earnings.
That’s why I’m a fan of unions, most people are just totally inept when it comes to maximizing their earning potential and they need to outsource that role to a union.
October 15th, 2009 at 1:58 pm
Was he an LOL CAT?
Nah, Lloyd grew up in public housing in Brooklyn, his dad was a clerk for the postal service.
October 15th, 2009 at 2:04 pm
They also have a graph of financial industry salaries vs a deregulation index which looks at least as good as that graph.
October 15th, 2009 at 2:08 pm
“Do you know what teh CEO of Goldman’s father did for a living?
Was he an LOL CAT?”
He was a clerk at the USPS. Jon Corzine’s dad was a farmer, Paulson’s dad was a wholesale jeweler (ok, Paulson probably had a reasonably plush upbringing), Rubin’s dad was a not particularly noted lawyer. All of them went to public high school.
October 15th, 2009 at 2:16 pm
In addition to distorting pay packages, the industry replaced lower educated tellers with ATM’s.
The graph reflects the MBA obsession and greed maximizing bonus structures, which incentivized a decade of junk products. We know what the combination did for America’s financial sector, banking and shadow banking.
October 15th, 2009 at 2:20 pm
As a class, these guys are very smart. They have figured out a way to get everyone–and I mean everyone–to act against their long-term interests in the service of giving these guys bushel baskets of money.
They are literally fleecing the vast majority of us, and we are letting them.
A gang of idiots can’t pull that off. Certainly not for 20 years. I mean, Goldman Sachs was part of the team that in collapsing their company as they made fortunes for themselves, nearly drove the rest of us into the great depression. Our punishment to this institution was a spectacular bailout of them and their entire industry, followed by record bonuses. This “heads I win, tails you lose” scam is BETTER than highway robbery.
October 15th, 2009 at 2:45 pm
Gotta remember, this is NOT about talent. The best people comes from all sorts. This is more about the Fredos of the world, who might be intelligent to some degree, but who aren’t truly more talented than people who don’t have their pedegrees. They populate many of the levels that are not viewed by the public.
October 15th, 2009 at 3:34 pm
As someone who went to the same schools as these so called “best brains” I really doubt that the idea that they are that smart. I mean we are not talking about whiz kids who started their own successful businesses at age 19, or kids who get into the best phd programs or law schools…
Actually, we are. Many people working in finance today are actually graduates of top law schools, or PhDs in math, computer science, physics, etc. Especially as the business has become much more dependent on mathematical modelling, Wall Street reacted by recruiting talent away from the universities.
When we are talking about wall street, we are talking about people like you. Mediocre talents who got into elite schools due to them having the family resources growing up to “prep” them for admissions to harvard or what not.
That used to be the case back in the 60s-80s, but it is not anymore. Many of the people I work with are staggeringly smart. You’ll always have the mid-level talents, but these days so many genuinely intelligent people have crowded into the field that there’s no way to get to the top anymore without having an analytical mind.
October 15th, 2009 at 4:56 pm
16: Myles, that’s a pretty amusing outlook on the world. As far as I can tell, most of the evidence indicates that letting Wall Street run your business means maximizing returns on the next 4 quarterly reports at the expense of long term fundamentals. There is no reason to believe that Wall Street actually knows anything about business.
October 15th, 2009 at 6:59 pm
Physicist Steve Hsu’s blog covers the brain drain from physics to finance quite well.
http://infoproc.blogspot.com/
You can also use physicists as, for example, nuclear engineers, as was done in the Manhattan Project. If so many physicists hadn’t gone into finance, we might have cost-effective nuclear power by now.
October 16th, 2009 at 3:03 pm
@28 the complete reliance on the Gaussian copula certainly reflects well on all those mathematical geniuses.
Felix Salmon, “Recipe for Disaster”
In the world of finance, too many quants see only the numbers before them and forget about the concrete reality the figures are supposed to represent. They think they can model just a few years’ worth of data and come up with probabilities for things that may happen only once every 10,000 years. Then people invest on the basis of those probabilities, without stopping to wonder whether the numbers make any sense at all.