Are Financiers Overpaid?

In a recent article, The Seduction of America (here) I discussed the question of how the very high earnings of some in the financial sector might be viewed as a negative overall for the economic health of the U.S.

If you go to that article you will find that I referenced the work of others, but at least one significant reference was omitted. I was unaware at the time, but this was addressed in a rigorous way in a very technical research paper entitled Wages and Human Capital in the U.S. Financial Industry: 1909-2006 by Thomas Philippon (New York University) and Ariell Reshef (University of Virginia), published in December, 2008. Read the entire paper here.

Philippon and Reshef (RS) found that financial sector compensation has had two peaks in the past hundred years: the 1920s-early 1930s and the late 1990s -2000s. Since both peaks coincided with disastrous financial collapses, it is legitimate to ask if this is coincidence or if there is causality. (This is my question, not RS.)

The researchers examine a number of possible relationships that might account for the two periods of high compensation. They rule out technology (computers, etc. did not exist in the first peak). They rule out education as a primary factor by comparing incomes for comparably educated engineers and financial workers.

In the following graphs, RS show that for bachelor degrees, there is comparable compensation for financial professionals compared to engineers in recent years (after trailing engineering compensation from 1965-1995). When graduate degrees are surveyed, those in finance have recently reached much higher compensation levels than comparably trained engineers.

RS find that the relative number of people in finance (investment banking, hedge funds, etc) has been unchanged in the 10% to15% range of all financial sector employment since 1930. The other two classifications have each been between 40% and 50% most of that time period. These relationships are shown in their graph:

However, compensation for the finance (RS call this “Other Finance”) has exploded (relative to compensation in credit and insurance businesses) since the 1980s, as shown in their graph below:

RS try to address several questions:

1. Has financial creativity been over compensated?
2. Can the excess compensation in finance be segregated into component parts?
3. Can the excess compensation in finance be related to effects in other parts of the economy?
4. Are the high wages in finance sustainable?

Question 1: RS make a rather circuitous argument about whether there has been over-compensation. My summary of their conclusion would be that they feel the topic to be subjective. They say:

…one could assess whether financiers are paid more than what that they would be paid under a properly defined “social optimum.” Research in economics and finance is not yet at the stage where we can answer that question from first principles. One step towards answering such a question is presented in Philippon (2007), where the optimal allocation of talent is analyzed in a dynamic general equilibrium model with credit constraints, career choices and industrial innovations. In that model, the financial sector can drain resources from entrepreneurial activities with positive externalities, but it can also alleviate the financial constraints facing the would-be entrepreneurs. This trade-off is important in practice. Unfortunately, many critical inputs of the model are not directly observable, which makes it impossible to measure the discrepancy between private and social returns to financial jobs. More research is clearly needed in this area.

Question 2: RS make the following determinations regarding the components of over-compensation:

a. 40% is higher unemployment risk.

b. 30% to 50% is rents.

Economic rent is a payment to a factor of production in excess of that which is needed to keep it employed in its current use.

RS do not identify the attribution for the other 10% to 30% of the excess compensation.

Question 3: There are a couple of factors discussed: The first addresses the rather esoteric question of whether social returns (for other occupations) are diminished when private returns (in finance) are overly attractive. Note the authors’ wording: “one’s view regarding economic externalities” which I read as “political viewpoint”. RS decline to draw a conclusion about diminished social returns. The second part describes how over compensation might steal talent from the regulatory agencies, leaving them without the skills to do their jobs.

Our research has two important implications for financial regulation. First, tighter regulation is likely to lead to an outflow of human capital out of the financial industry. Whether this is desirable or not depends on one’s view regarding economic externalities. Baumol (1990), Murphy, Shleifer, and Vishny (1991) and Philippon (2007) argue that the flow of talented individuals into law and financial services might not be entirely desirable, because social returns might be higher in other occupations, even though private returns are not. Our results quantify the rents earned by employees in the financial industry in the late 1990s and early 2000s. These rents explain the large flow of talent into the financial sector. At this stage, however, we cannot assess whether the inflow was too large from a social perspective.

Our results have another important implication for regulation. Following the crisis of 1930-1933 and 2007-2008, regulators have been blamed for lax oversight. In retrospect, it is clear that regulators did not have the human capital to keep up with the financial industry, and to understand it well enough to be able to exert effective regulation. Given the wage premia that we document, it was impossible for regulators to attract and retain highly-skilled financial workers, because they could not compete with private sector wages.

Our approach therefore provides an explanation for regulatory failures.

Question 4: RS are very clear in their conclusion here:

From the mid-1920s to the mid-1930s, and from the mid-1990s to 2006, however, the compensation of employees in the financial industry appears to be too high to be consistent with a sustainable labor market equilibrium.

This paper is not casual reading if you try to follow the analysis in detail, but the conclusions about compensation issues are relatively easier to extract.

Comments

[Trane250:]

I doubt whether most of the finance professionals could make it through the freshman year in an engineering course. Come to think of it, only a small percentage of those who start out in engineering actually graduate in that discipline.

A society that values financial manipulators over designers and producers of products is on a down hill slope.

Jul 09 10:29 AM

[rm:]

Isn't that the way of things? A topic, or a sector, gets hot... there's an exciting story to tell, brain power and resources get over-diverted... eventually, that market becomes overloaded with participants, driving profits down, or it collapses... then, on to the next "thing."

Have we reached equlibrium yet?

Jul 09 10:31 AM

[sleepless_o...:]

The topic of this research paper and its conclusions are intuitively obvious. I got a better feel about compensation in the finance sector from your earlier article and from an article in the Atlantic Monthly by Simon Johnson. On the other hand, this paper was published well before the other two, so maybe this work has guided the intuition.

Thanks for reporting on this.

Jul 09 11:33 AM

[kruser53:]

I am intrigued by the attempts to value the work content of financial engineering. In some aspects, I think it should have negative value. Can some economist do a results based analysis? The researchers whose work is discussed in the article carefully avoid addressing the systemic effects of financial innovation.

Is inventing a new burgulary tool of value to society because it increases the burgulars income? Perhaps the burgular should pay a bigger debt to society for having used the tool.

The premise of the researchers work is that the value of the financial innovation is positive. Could that be a false premise?

Jul 09 12:16 PM

[basehitz:]

Are financiers overpaid?

Does a duck have lips?

quack quack

Jul 09 03:19 PM

[TinyTim:]

John-
Thanks for the attention to the Philippon & Reshef paper. I know this is a pet subject of yours.
I also had to resist the urge to answer your title, because even though the answer may seem intuitive, it is always useful to read a rigorous analysis to be sure of your assumptions.

Jul 09 05:26 PM

[Tony Petroski:]

I didn't read the paper, having only a financial bachelors degree and therefore not smart enough. Is the fact that so many financiers live and work in New York factored in. Are they comparing a financier who makes a large nominal income but since he lives in New York, nets out comparatively low to an engineer living and working in Detroit?

It's a certainty that regulators will get captured by those they are regulating in part because they can make more money working for the regulated. Therefore plans to fix markets through more regulation will backfire. I'm afraid the Pope was wrong on this one.

The Soviet Union had approximately one "regulator" to watch every producer to make sure there was no "wrecking" of the 5-year-plan. We saw how well that worked out.

What does work is free markets regulated by creative destruction. If you don't want the financiers to get overpaid, don't send them your money.

Jul 09 06:50 PM

[Steven Hansen:]

i watched an old BBC documentary while i lived in england on this subject in the early '80s exposing exactly what you are saying.

as an engineer trying to execute major projects, it was obvious that in the UK the greatest minds were going into insurance and banking. first of all, the insurance and banking systems were miles ahead of america. construction was miles behind.

the large paychecks were in insurance and banking. i used to joke that a brit mom never told her kids to be engineers...... "you want to grow up to work in insurance and banking."

we live in an age where you can make more money manipulating money than you can by producing. as an engineer this saddens me but it is what it is.

Jul 09 07:06 PM

[Mark54:]

absolutely... got an ME and MBA and bond/finance math is a joke. Even the quant stuff misses the point of stress testing that is grilled into engineers.


On Jul 09 10:29 AM Trane250 wrote:

> I doubt whether most of the finance professionals could make it through
> the freshman year in an engineering course. Come to think of it,
> only a small percentage of those who start out in engineering actually
> graduate in that discipline.
>
> A society that values financial manipulators over designers and producers
> of products is on a down hill slope.

Jul 23 08:56 PM

[Mark54:]

I think it would be interesting to have the earnings normalized for sector profits. Perhaps too simplistic but I am of opinion that immediately "sucessful" risk was perhaps rewarded too quickly.... big fan of deferred incentive comp and clawbacks

Jul 23 09:00 PM