We have been told that one of the principal reasons (though by no means the only one) Detroit got into trouble is that UAW (the United Auto Workers) ensured that the wages of auto workers in the city were too high.
For two decades now, wages in the financial industry have been too high. In the 1970s, it was not uncommon for people to move from banking to manufacturing or retailing, and back. By the 1990s, this became impossible as the wages in banking (and in the entire financial services business) went through the roof while other folks had more modest gains. The curious fact to note was that there was no special expertise or skills that justified this.
An MBA with a few years’ experience does not become a genius; yet if this experience was in banking, his or her compensation became much higher than that of erstwhile classmates who went into other fields. This situation worked even with identical skills. A computer programmer, who worked in an information technology (IT) company, could move to an investment bank performing the same tasks as before and get a 100-200% wage increase. Even a secretary at Goldman Sachs supposedly made more money than a vice-president in a company in another industry. I wonder whether typing and filing at Goldman is intrinsically different from typing and filing at more humble locales!
This two-decade-long persistence in irrationally high wages in the financial industry has not been explained by any economist, except to whisper under the breath that there are labour market rigidities. Presumably, labour markets (unlike financial markets) are not information-efficient; they can be fooled for 20 years, and serially correlated error terms can persist. In any event, in the face of this non-explanation, I always found it difficult to explain to folks why I left a bank and went into the IT industry where I was paid less and where I actually had to work hard. I used to get away by telling folks that it was “entrepreneurial challenge” and not compensation that interested me, skipping over the fact that I did not get promoted to the top table in my bank and, hence, I left.
It appears that the financial sector problems today are not very different from those of auto and Detroit over the last few decades. There is definitely excess capacity in the industry. Anyone who gets fired from a bank seems to be able to join a hedge fund or a private equity fund as more exotic intermediaries are being created. Till now, the capital invested in the financial industry (and there has been a lot of capital attracted by the high returns...if you exclude 2008, and very poor returns if you include 2008!) has been used in an asymmetric fashion. If the great trading strategy works, the traders get big bonuses. If it does not work, the equity holders can take the hit (for example, Barings Bank and Lehman Brothers Holdings Inc., etc.). No economist has been able to explain why equity holders allowed financial sector executives to get away with this really good deal. Where are the Michael Jensens and the William Mecklings to explain this aberration in managerial incentives? I know of a senior foreign exchange trader who got a huge bonus one year when he made a lot of profits for his bank. The next year, he was making losses. Instead of his bonus getting clawed back, he simply moved to another bank that gave him a joining bonus larger than the “performance” (performed by putting the bank’s capital at risk, needless to say) bonus he got from his previous employer. While no plausible explanation has come from any contemporary economist for this phenomenon, any serious neoclassical economist would have told you that no labour market, however rigid, can persist for too long with these excesses and asymmetries. The only question academics need to debate now is whether two decades has been too long for the correction to be put in place.
Be that as it may, the long persistent error of the labour markets is coming to an end. The excess capacity in the industry is being wrung out (Lehman Brothers, Washington Mutual Inc., Wachovia Corp., Bear Stearns and Companies Inc., Merrill Lynch and Co. Inc., Bradford, etc.). The industry is slimming, facing up to its hubris as the biggest bubble of recorded times is bursting. There are no Japanese competitors such as the ones who hurt Detroit. This is occurring pretty much with all competitors. But just like UAW workers have been forced to take wage cuts from earlier unrealistic levels, I think we will see a decline in wages in the financial sector. The only question will again be whether this will happen quickly or slowly. In any event, parents of teenagers should plan careers other than investment banking for their children if high wages are what they are after.
Jaithirth Rao, a former banker and technology entrepreneur, divides his time between Mumbai, Lonavla and Bangalore. Send your views on this column at conservative corner@livemint.com
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