The emergency rescue of the financial sector drew attention to the phenomenal financial sector wages. Nicholas Kristof reported in his column in The New York Times that the CEO of Lehman Brothers, one of the first banks to go bankrupt in September, had won 45 million dollars in 2007, and half a billion between 1993 and 2007.
This is not an exception: the series built by Thomas Piketty and Emmanuel Saez showed that the proportion of income of the 1% richest Americans has increased constantly since the early 1980s. But even compared to other rich people, the "golden boys" of finance have seen their incomes soar. A recent study by Thomas Philippon and Ariell Reshef1 shows that at equal competence, an employee earned the same wage in the financial sector as in the rest of the economy in 1980. But a gap emerged in the 1980s and has continued to widen since. In 2000, wages were 60% higher in finance than in other sectors. This is partly explained by an increase in the number of highly skilled employees in finance, and an increased risk of unemployment, but only in part: Philippon and Reshef calculates that financial sector wages are 40% above what we might have expected based on these factors. The last time they were so high was in 1929...
Naturally, the wage issue was part of the discussions around the Paulson plan, which authorizes the government to spend up to 700 billion dollars to buy shares the market does not want. It seems unfair for the taxpayer to pay from his pocket the mess created by others who earn 17,000 dollars an hour. Ultimately, no ceiling on executive compensation has been imposed on banks that sell shares to funds set up by the government, although some limits were placed on "golden parachutes". In any case, as Thomas Piketty pointed out in his liberation column last week, a wage cap is easily circumvented, and it would be preferable to tax high incomes, as the Roosevelt administration did.
If paying the bankers (a lot) less or taxing them (a lot) would certainly be more desirable from a moral point of view (not to mention considerations of equity), would it be harmful in terms of economic efficiency, as many economists suggest? Is there a risk of discouraging the most talented to work hard and innovate in finance? Probably. But it would almost certainly be a good thing. The temptations to join the financial sectors are even stronger for the elite of undergraduates than what Philippon and Reshef estimate. The “Harvard and Beyond” survey, a survey of several cohorts of Harvard graduates conducted by Claudia Goldin and Larry Katz showed that in 2006 those who worked in finance earned almost 3 times more (195%) than others, after controlling for grades in college, standardized scores at entry, choice of major, year of graduation, etc.2 The temptation for a young talent to work in this sector is enormous: the survey showed that 15% of males Harvard graduates of the classes 1988-1992 were working in finance, against only 5% of those of the 1969-1972 class. More generally, the massive deregulation of the financial sector, which began in the 1980s, and the opportunity to make extraordinary profits, has been accompanied by an increase in the number and qualifications of employees in this sector. Again, according to Philippon and Resheff, one has to go back to 1929 to see such a gap between the average education of an employee in the financial sector and one in the rest of the economy. The complex financial products, but also the evolution of standards in the social sectors over the past 30 years has made the financial sector particularly attractive to any graduate, intelligent as he may be.
What the crisis has made bluntly apparent is that all this intelligence is not employed in a particularly productive way. Admittedly, a financial sector is necessary to act as the intermediary between entrepreneurs and investors. But the sector seems to have taken a quasi-autonomous existence without close connection with the financing requirements of the real economy. Thomas Philippon calculates that the financial sector, which accounts for 8% of GDP in 2006, is probably at least 2% above the size required by this intermediation.3 Worse, the sub-prime crisis is almost certainly in part linked to the fact the needs of the financial markets (the insatiable demand from banks for the famous “mortgage backed securities”) led to excessive borrowing and a housing bubble. Watching the events of the last few days unfold does make us one want to send some of the finance CEOs back home. More pragmatically, the disappearance of their exorbitant earnings may encourage younger generations to join other industries, where their creative energies would be socially more useful. The financial crisis could plunge us into a severe and prolonged recession. The only silver lining is that it could cause a more realistic allocation of talents. One must hope that the bail-out packages in Wall Street and in Europe does not convince the best and brightest that the financial sector is still their best option.
1 Thomas Philippon and Ariell Reshef “Skill Biased Financial Development: Education, Wages and Occupations in the U.S. Finance Sector” NYU Stern Business School mimeograph, , September 2007
2 Claudia Goldin and Lawrence Katz “Transitions: Career and Family Life Cycles of the Educational Elite” American Economic Review (2008) 98:2 pp 263-269