It is now open season to attack the bankers who fanned the speculative fires that have now scorched the world economy.
The annual meeting of the World Economic Forum at the Swiss town of Davos saw ample finger-pointing at the former masters of the universe, even as Russia’s Vladmir Putin and China’s Wen Jiabao used the platform to hit out at America and its addiction to debt. Iconoclastic author Nassim Nicholas Taleb said: “We should not trust bankers. Look at their track record.”
US President Barack Obama did not attend the Davos shindig. But he capped a month of popular ire against banker salaries and bonuses—many Americans were scandalized when told that Wall Street bankers had collected $18.4 billion of bonuses in a year when taxpayers bailed out their organizations. Obama has called these payouts shameful and some reports suggest that his administration could move to place curbs on Wall Street pay.
Valid though these concerns are, there is a danger that all this could degenerate into a grand morality play between the good guys and the bad guys.
We need bankers. Every modern economy requires a financial system to bring risk-averse savers and risk-taking entrepreneurs together. Some countries do this more through commercial banks and some more through capital markets. Both models are prone to trouble—remember that “financially repressed” Japan in the 1990s had as severe a banking crisis as “financially innovative” America has today.
The problem is that banks and other financial institutions are inherently unstable animals that can pull an entire economy down with them—and hence need tight regulation. There is a growing global consensus on this right now.
Where does that leave bankers and their stratospheric salaries? Recent research suggests that legislative action may not be needed to bring finance sector salaries closer to those in the rest of the economy. The deflated bubble and stricter regulation of banks will almost automatically do the job.
Thomas Philippon of the NYU Stern School of Business and Ariell Reshef of the University of Virginia have recently done a detailed study for the National Bureau of Economic Research on how wages and skills in the US financial industry have changed between 1909 and 2006.
They have charted out a U-shaped pattern over the period of close to a century. From 1909 to 1933, the US financial sector was a high-skill, high-wage island. Then there was a huge change as “the financial industry rapidly lost its high human capital and its wage premium relative to the rest of the private sector”. This phase lasted till around 1980. And the finance business once again became a high-skill, high-wage one after that.
It is pretty obvious that these long-term shifts are in sync with the waves of regulation and deregulation of the US financial system. The wage difference between the finance industry and the rest of the US private sector first narrowed and then widened. Part of it is justified: The finance industry offers corporate finance skills—managing credit risk and arranging capital through initial public offers—that the rest of the economy needs. But between 30% and 50% of the excess wages are accounted for by what economists call rents, or the difference between what a factor of production is currently paid and what it should be paid to remain in its current use. “In that sense, financiers are overpaid,” say Philippon and Reshef.
The decline in rents and a narrower gap between wages in finance and other skilled professions will make the former a less attractive option for bright young things. Philippon and Reshef point to two implications.
First, would fewer young professionals designing collateralized debt obligations and more building bridges and tunnels be a more productive social arrangement? It is hard to say, though there are many economists who believe that social returns from finance and law are lower than the private returns in these occupations.
Second, the fact that wages are at stratospheric levels in the finance business often ensures that the deal makers are smarter than the regulators who have to watch over them. They can run circles around regulators even as the money power and prestige of their organizations lead to regulatory capture, where the watchdogs start protecting the interests of the industry rather than of investors.
The attack on Wall Street is not likely to stop anytime soon, even though parts of it will be moralistic and envious. India is unlikely to see anything similar. But the coming deflation of salaries in global investment banks and trading desks as well as the contraction in the worldwide financial industry are bound to have ripples here. The implosion of the financial industry and the cracks in its theoretical edifice could have effects on career choices in the coming years.
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