American Insurance Group (AIG) was saved from collapse by $170 billion of government funds. The government rescued the company because it feared that the failure of the insurance giant would reverberate through the financial system, and further damage the real economy, already suffering its worst downturn in almost 80 years. The problem was caused not by plain vanilla insurance, but by complex derivative contracts (now estimated at $1.6 trillion), which suddenly generated tens of billions in losses when rosy assumptions about the future turned out to be false.
Now, it turns out that the members of the AIG Financial Products group, which created the mess, are receiving hundreds of millions of dollars in bonuses. Individual amounts of at least $1 million went to some 73 employees. The company has offered various defences: These are contractual obligations (agreed on before the crisis), and, according to the current CEO, they are necessary to “attract and retain the best and the brightest talent”. In fact, the claim (note the irony) is that only these executives can clean up the mess they created, by unwinding the various positions taken in different complex financial derivatives, since they know best what they did.
I want to put aside all the moral, ethical and legal dimensions of this situation, which has elicited outrage from across the spectrum of society. What was agreed upon by the firm, what the government knew, what can be done now, all this will be sorted out over the next weeks and months. I’d like to look, instead, at the market for talent, and the economics of high pay.
Who earns large sums of money in modern society? Doctors, pilots, scientists, and others like them are highly skilled and talented, and definitely get paid much more than average. But they typically do not earn millions of dollars annually. Successful business entrepreneurs can earn much larger amounts. They are rewarded for satisfying wants better than others can, perhaps by designing new products and services, or simply being more efficient. Entertainers and sports stars can earn in the millions. Mass entertainment (including sports) has increased the earning power of the most popular actors and singers, and best-performing athletes. There are limits to the number of slots that are available at the highest levels of performance, both because of limits to natural abilities (only a few cricketers are good enough to play for their country), and limits to the audience’s loyalty and attention span. There can be only one national team, and only a certain number of teams in a professional sports league.
Mass markets and competition can, in some cases, produce highly skewed earning distributions, where the top performers earn phenomenal amounts. Is that what happens on Wall Street? Are hundreds of financial sector employees so valuable that they are worth being paid over a million dollars? Economic theory says that workers will be paid the value of their marginal product. If their skills are rare, and cannot be duplicated, they will earn “economic rents”— amounts greater than what they could earn elsewhere—but their marginal value is determined on the demand side. So scale helps increase the value of such skills; thus recording and broadcasting technologies boosted the earnings of the top singers, actors and athletes.
Certainly Wall Street’s top performers are able to generate large sums of money for their employers, since they engage in large-scale financial transactions. That is supposedly why they earn such large amounts. But what are they really doing? Are Wall Street’s top earners really earning economic rents for skills that are in very short supply? Are they super smart, or do they have nerves of steel that few can match? I don’t think so.
Most of the high incomes on Wall Street (excluding CEOs and the like) are earned by traders. Their jobs are stressful, and there are likely few people who can do such jobs, but what really boosts their earnings are barriers to entry and market imperfections. Some of the barriers are necessary: Even traders have to be trained and certified, though clearly they are not being trained well enough. But there are restraints to competition in these markets that inflate earnings, in the form of a small, tight network of firms and people.
The situation with many financial products reminds me of that of common stocks 30 years ago. Commissions were regulated and high. Brokers controlled information, and kept it from retail investors. They claimed special expertise, and earned incomes that were basically a form of toll-taking for buying and selling stocks. With deregulation and new technologies that increase market access and transparency, commissions have plummeted, and the old stockbroker model is dead.
Bonds, complex financial derivatives and other more esoteric securities are not as easy to trade as stocks, and their markets will never be as efficient, but we have to move away from a situation where 21st century financial products are being traded in 18th century-style institutions that collect tolls and misallocate talent.
Nirvikar Singh is professor of economics at the University of California, Santa Cruz. Your comments are welcome at firstname.lastname@example.org