Paper of the Year

As bankers’ pay, at least for the fortunate ones at Goldman and JPMorgan, returns to pre-crisis heights, a paper by Thomas Philippon and Ariell Reshef is becoming everyone’s favorite citation. The paper, “Wages and Human Capital in the U.S. Financial Industry: 1909-2006,” got a first wave of attention from Paul Krugman, Martin Wolf, and Gillian Tett back in April (see Philippon’s web page for links). It’s also the subject of Justin Fox’s column in Time; see Fox’s blog for links to other discussions. (I also cited the paper in my ramblings provoked by Calvin Trillin.) The earlier references were mainly for Philippon and Reshef’s finding that pay in the financial sector correlated strongly and negatively with the degree of regulation — pay was higher in both the 1920 and in the post-1980 period, and lower under the stricter regulatory system created during the Great Depression. More recent references, including Fox’s column, have focused on the idea that people in finance are overpaid.

Since most articles have just focused on the headlines, I’m sure Philippon and Reshef are going to be misquoted all over the Internet. For example, at least two articles focus on a figure of “30% to 50% of financial-sector pay” in ways that are not quite correct. So I’ll try to lay out what they actually say.

Section 1 (see Figures 1-3) lays out the facts. Jobs in the financial sector were more complicated and more mathematical, required more education, and were more highly paid both before 1930 and after 1980.

Section 2 asks why this happened. They regress relative education (the share of highly-educated people in the financial sector relative to the rest of the economy) and relative wage (the ratio of wages in the financial sector to wages in the rest of the economy) against several explanatory variables:

  • the degree of information technology use in the financial sector
  • the amount of financial innovation (represented by the number of patents)
  • the amount and complexity of corporate finance activity (represented by the share of IPO activity and the amount of credit risk)
  • the amount of deregulation (interstate banking, Glass-Steagall, etc.)

Not all regressions use all explanatory variables, but the results (Tables 3 and 4) are consistent: deregulation is the only explanatory variable with a strong significant effect on both relative education and relative wages. In Table 3, for example, “deregulation alone accounts for 90% of changes in education and 83% of changes in wages.” Patents and IT intensity affect relative education but not relative wages; indicators of corporate finance activity affect wages but not education.

Now, none of this so far implies that people in finance are not worth their higher salaries. Deregulation could have created an environment in which the productivity differential between higher- and lower-skilled people became higher in finance than in other industries, making them more valuable in finance than elsewhere. Section 3 analyzes this issue. Figure 7 shows that, since the mid-1980s, the earnings of people in finance have shot up relative to the earnings of engineers (outside finance), even with the same level of education.

Figures 10 and 11 are based on the concept of a “benchmark” wage for finance. This is the wage that you would expect people in finance to get based solely on their relative education level (which we know went up after 1980), the skill premium (the amount that more highly-skilled people earn throughout the economy, which has also gone up since 1980), and the relative risk of unemployment (if you are more likely to be fired, you should be paid more to compensate). Figure 10 shows that given all this, you would have expected finance salaries to go up about 20% relative to the rest of the economy since 1980, but in fact they have gone up about 65%. The excess wage (Figure 11) — the difference between the amount people in finance make and the amount you would expect them to make — reached about 0.4 this decade; that means that if the average American is making $100, you might expect people in finance to make $125 (based on education, skill premium, and unemployment risk), but instead they are making $165.

The last set of regressions attempts to determine whether the excess wage in finance is due to characteristics of individuals in finance that are not observable in the previous regression. They do this by looking at the Census Bureau’s Current Population Survey, which is an individual-level sample. They determine that over the entire sample period (1967-2005), even after controlling for individual characteristics, working in finance is worth a 4.4% wage premium (Table 5; 8.3% for people with post-graduate education). Looking at specific time periods (Table 6), the wage premium only appears in 1986; from 1986 through 2005 it averages 6.0%. Comparing these wage premiums to the excess wage for the industry as a whole, they conclude that 30-50% of the excess wage is not due to differences in ability, but represents pure rents.

Note that the wage premiums calculated here cannot be compared to the excess wage in Figure 11, because Figure 11 is estimated using industry-level data, and the estimates in Tables 5-6  use the CPS, which suffers from top-coding (incomes are reported in categories, and there are no categories for the super-rich). My interpretation is that Figure 11 is the best way to see the size of the excess wage, since it doesn’t suffer from top-coding; Tables 5-6 are primarily useful for showing what proportion (30-50%, according to Philippon and Reshef) of that excess wage cannot be explained by differences between individuals.

So note in particular that the 30-50% number in the paper does not refer to the wage premium of people in finance; it is the proportion of the wage premium that cannot be otherwise explained. The excess wage itself depends on how you measure it. In Figure 11 (difference between finance wages and what finance wages would be expected to be based on education, skill premium, and unemployment risk) it gets up to 40%, but only in the last few years.

In any case, it’s clear that people in finance make more than people not in finance, and that you can’t explain it away just by saying they are more educated or their jobs are more risky. Now in one sense the defenders of high Wall Street pay are correct: people are probably getting roughly what they could make if they walked across the street and went to another bank. But that doesn’t answer the question of whether the whole industry is making a mistake and transferring wealth to employees that should go to shareholders.

By James Kwak

22 responses to “Paper of the Year

  1. “whether the whole industry is making a mistake and transferring wealth to employees that should go to shareholders”

    ?

    I don’t see anything in this post that suggests the finance industry as a whole is providing good value for money, so the rents going to employees are coming from shareholders. My baseline hypothesis (derived from just looking around) would be that both employees and shareholders in the finance industry are deriving rents from (aka “ripping off”) everyone else who is not in finance.

  2. The problem is not employees versus shareholders.

    The problem is the useless activities of Wall Street extracting effective rents from the productive sectors of the economy.

    These firms are leeches on society. Whether their spoils go to their non-productive garbage employees or to their passive shareholders is not really the issue.

  3. If you convince “risky” Joe to take out a $300.000 mortgage 30 year at 11 percent and then, if with a little help from the credit rating agencies you can convince risk-adverse Fred that this mortgage packed together with other similar is so safe he should be satisfied with a return of 6 percent, then you can sell Fred that mortgage for $510.000 and pocket a tidy an immediate profit of $210.000. In such a scenario who can be surprised by high bonuses?

    Those that complain about obscene bonuses should have spoken out before but instead they stood silent in awe, believing that nonsense of the risk of the financial system being diluted in the oceans of the world or landed in the arms of those strong enough to manage them.

    Anyone complaining about bonuses now, could do better questioning the validity of the low interest rates by which the Fed currently subsidizes primarily the financial sector.

  4. The fact that they can control the legislators and regulators has much to do with how they set up the bonus incentives. Since they seem to own members of both parties , they can make the rules.Finance industry fed politicians are the first step , modestly successful earnings seals the deal.

  5. One thing that I’ve found puzzling about the debate over compensation in the financial sector is the nature of the business. If you work at a grocery store, you take home the overstock. If you work at a clothing store, you get your outfits at cost. These guys are working with the exact commodity that they’re paid in and it’s extremely likely that’s the reason they’re there.

    The strangest thing to me is the apparent shock and revulsion people seem to be experiencing. I’m not sure if either financial executives deserve their compensation or if it should be handbraked by regulation — I’m a designer after all, not an economist.

    Nevertheless, the whole scenario reminds me of that parable about the frog who grudgingly lets a scorpion sweet-talk it into giving it a lift across a river. When they get half-way through, the scorpion inevitably stings the frog. As the astonished and dying frog sinks below the surface with the doomed scorpion on its back, the latter says “Sorry, I’m a scorpion. That’s just what I do”.

  6. Section 2 asks why this happened. They regress relative education (the share of highly-educated people in the financial sector relative to the rest of the economy) and relative wage (the ratio of wages in the financial sector to wages in the rest of the economy) against several explanatory variables:

    the degree of information technology use in the financial sector
    the amount of financial innovation (represented by the number of patents)
    the amount and complexity of corporate finance activity (represented by the share of IPO activity and the amount of credit risk)
    the amount of deregulation (interstate banking, Glass-Steagall, etc.)

    Now that’s a cornucopia of worthless rent-seeking!

    Why should an ostensibly mature sector have needed to keep becoming more convoluted? Isn’t the genius of capitalism supposed to get simpler and more “efficient”?

    Once again we see the fundamental lie of capitalist ideology. It promised general prosperity and greater simplicity. It was lying about both.

    And we can never emphasize enough the opportunity cost of taking so many people who in theory were among the smartest, the most potentially constructive, and simply throwing them down a rathole to accomplish NOTHING.

    Worse than nothing: To join organized crime and act as predators and thugs against society.

    When the Nazis invaded Poland and then the Soviet Union, they sought to physically exterminate the native intelligentsia and educated class.

    As we’ve seen with America’s adventure in financialization, there are other ways to liquidate the educated class so that it can contribute nothing.

  7. Why do you blame capitalism when it would be more right to blame regulators for not doing their job right? Is capitalism to be blamed for not discovering a Madoff? Is capitalism to be blamed for regulators allowing unbelievable low capital requirements for anything with an AAA rating attached? I truly believe that basic and simple regulations are needed and can be very good but looking at what regulators have been doing and thinking over the last decade I would almost prefer no regulation at all… at least this crisis would not have happened.

    Also if you educate your children about the importance of having a good credit score that qualifies them as good and servile customers of financial services to such an extent that it sometimes would seem more important than your children’s school grades… how can you expect something different? Are you going to carve in your credit scores on your tombstones?

  8. It is very simple: without effective regulation to maintain appropriate proportion of finance to the rest of the economy (typical in all oligarchic situations), the finance community is free to do as it wishes, including bolstering its ranks with the best and the brightest. Why reward shareholders, when you can buy all of the influence you need to maintain economic control.

    It’s just verification that the story hasn’t changed, and, further, that it won’t (if the reregulation ends up as weak as it appears), especially if campaign and lobbying laws aren’t changed to modify economic incentives for long run balance. And, by the way, it is now clear that the next bubble is well on its way, and ready to come to a community near you. And, further, the media is being highly cooperative, the Baseline Scenario is one of the few outlets that is telling it like it is.

  9. What is the correlation between financial industry salaries and the propensity for the Fed to produce bubbles through cheap money?

    What is the correlation between financial industry salaries and it being a common Wall Street belief that risky bets gone south will likely be bailed out by the Treasury and Fed?

  10. The incentive comp (aka bonuses) became skewed when the incentives became volume based with no considerations for quality. This began in the 80’s when professions became businesses and professional ethic was lost along the way. It is after all the business of finance, not the profession of finance.

  11. I have no idea why you’re hectoring me about people turning their children into consumers. When I hear the word “consumer” I reach for my revolver.

    As for blaming the regulators, I’d rather just get rid of the criminals rather than have to rely on the cops not to be corrupt. Then we could get rid of the corrupt cops too.

  12. You just proved my point… about some wanting to discuss only their political agendas on Baseline.
    Thanks

  13. finally, a sane person around here

  14. You ought to know, with your vile defense of the bankers.

    “It’s the regulators’ fault!”

    You mean the same regulators bought and paid for by those same banks? You mean the regulators working with legal tools gutted at the behest of those same banks?

    Tell me the banks didn’t get rid of Glass Steagal. Tell me the banks weren’t behind the CFMA. Tell some more lies, since that’s the only thing which can prop up your zombie political agenda.

    Why not just go all the way and blame the predatory borrowers? Especially those in the inner cities, right?

  15. Well if you need to defend the regulators in order to be able to attack the bankers that is your problem. But in my world the regulators are supposed to be above the bankers… and so if you do not think that is possible what is it you want to achieve? A world with the regulators as bankers?

    I know what I want to achieve. I have been writing about it for many years. I want to get rid of those capital requirements that discriminate in favor of those AAA that do not need it and in favor of those TBTF that no one seems to want.

  16. One argument *for* high finance pay is the actual leverage that the job entails. One person can be managing hundreds of millions of dollars (if not more). Lets assume that markets are NOT efficient… and that certain people can beat the market portfolio by some X%. Shouldn’t that person be paid the portfolio notional * X% * some incentive compensation? Lets assume this one guy can beat the market (consistently) by 5%, and he takes the standard 20% (as is hedge-fund pay). If you have a 100MM portfolio, that’s 1MM dollars.

  17. If you work in a bakery, you have leftover extra pastries to take home.

    If you work in a software company, there is all kinds of leftover hardware and software to take home.

    If you work in finance, guess what there is leftover to take home?

  18. The article points out that pay in the finance sector increased when greater innovation was allowed, but it failed to discuss how this “innovation” provided any real value to the economy. Who cares about financial innovation. In the end it is usually about taking money from other investors. In the early years of the 21st century hedge funds mad huge amounts of money making quick trades in and out of mutual funds. That was a great innovation for the very few who could afford to invest in those funds, but it came at the expense of other mutual fund investors who’s returns were negatively affected. This “innovation: was just a way for the rich to steal from the rest of us.

    You can invent all the financial instruments you like, but in the end the total return on all investments come form company profits. Simple is fair, “innovation” is esentially unjust.

  19. You fail to complete the logic. If a manager should get a reward for beating the market, he shoud be penalized when he underperforms. I don’t mean getting paid less, but actually paying the same standard 20% back to the investors. In other words he would have negative income.

    Very few managers consistently beat the market. Why should they be rewarded in the good years and not be penalized in the bad?

  20. I’m not convinced this sort of thing is adequately adjusting for the difference in hours worked.

    Even right out of school, if I sign up for a finance job with 80 hours a week, I should probably get paid substantially more than twice as much as my engineer friend who works 40 hours (my declining marginal utility of money and increasing marginal utility of leisure). Second, if you compare us 5 years down the line, we are no longer apples-to-apples. I have acquired the equivalent of 10 years of work experience to my engineer firend’s 5. There is no particular reason to think this extra experience should affect my compensation linearly either. It may well be (and I would argue that it is in trading positions) that the job simply cannot be done by 2 people who work 40 hours a week. The knowledge gained from spending 80 hours a week with the market simply must be concentrated in one decision-maker.

  21. “The excess wage (Figure 11) — the difference between the amount people in finance make and the amount you would expect them to make — reached about 0.4 this decade; that means that if the average American is making $100, you might expect people in finance to make $125 (based on education, skill premium, and unemployment risk), but instead they are making $165.”

    An employer paying $165 can be more selective than one paying $125. The difference between two individuals with the same nominal education, job skill level, and job unemployment risk, when one is offered premium pay and the other is refused it, is presumptively significant. Calling the resultant difference in wage “excess” rather than “premium” is a political choice.

  22. ND:

    Your engineer friend may be far more productive in 40 hours than you in 80 hours.