Employees in Financial Sector Are Overpaid

In a recent paper, NYU's Thomas Philippon estimated the size of the financial sector. The model he used was surprisingly accurate from 1920's through the 1990's. But as this chart from his paper shows, something happened in the late 1990's that threw off the model.

Here are Philippon's possible explanations for the discrepancy:

Up to the 1990s, the model seems able to predict most of the changes in the size of the financial sector. The model falls short in the more recent decade. Since the model forces all the demand for financial services to come from domestic firms, the discrepancy could reflect the globalization of the finance industry. There could also be an increase in financial services provided to U.S. households. Alternatively, it could be that the financial sector is too large and should be reduced.

In another new paper (this one is more preliminary than the first), Philippon and University of Virginia's Ariell Reshef try to explain why bankers, traders, and other financial sector employees get paid so much.

It first turns out that these workers didn't always used to be so richly rewarded:

From 1900 to the mid-1930s, the financial sector was a high-education, high-wage industry. Its workforce was 17% more educated and paid at least 50% more than that of the rest of the private sector. A dramatic shift occurred during the 1930s. The financial sector started losing its high human capital status and it wage premium relative to the rest of the private sector. This trend continued after World War II until the late 1970s. By that time, wages in the financial sector were similar to wages in the rest of the economy. From 1980 onward, another shift occurred. The financial sector became a high-skill high-wage industry again. Even more strikingly, relative wages and relative education relative to the private sector went back almost exactly to their levels of the 1930s.

What accounted for much of this change? Deregulation of course.

We find a very tight link between deregulation and human capital in the financial sector. Highly skilled labor left the financial industry in the wake of the depression era regulations, and started flowing back precisely when these regulations were removed.

During the recent surge in wages for financial sector workers, Philippon and Ariell find that technology played a relatively small part in explaining higher pay:

Computers and information technology also played a role, but, contrary to common wisdom, they cannot account for the overall picture for the simply because the financial industry of the late 1920s looked remarkably like the one of the late 1990s.

The researchers also looked into the role of risk: finance sector employees are more likely to lose their jobs than average. How much does that account for the rise in pay? About six percent of it.

The duo next create a model of finance sector wages and come to a very interesting conclusion:

We find that in 1920-1940 and in 1990-2005 employees in finance are overpaid.

Why is this the case? Some economists have argued that the flow of highly-skilled workers into fields like law and finance may not be desirable because even though the private returns are higher in these jobs (i.e. they pay more), social returns in some other less-well-paying jobs are higher.

Here is a chart showing the predicted and actual wages in the financial sector:

It implies that workers in finance are overpaid by 40 percent.

Comments

[fatcat:]

Very interesting,Zubin...I graduated with a finance degree in 1972 and interviewed with several banks.The salaries offered were 30% below comparable government jobs..the guys I graduated with were starving for a few years,but eventually they made it up with sleazy side deals that come your way in banking.Then they got hit again by the consolidations in the industry.

This is the 1st article I have seen that addresses this,but surely somebody wrote a book..

2008 Sep 26 07:51 PM

[Steven Hansen:]

in the UK, banking and insurance have always been the highest paid professions. Zubin, sorry but you have overanalyzed the reason. they are the paid high because of the amount of profit they generate combined with the lack of supply of high caliber talent who can be relied on to bring home the bacon.

2008 Sep 27 12:58 AM

[Maxi:]

I heard somewhere that these banks are paying millions of dollors to CEO's every month even though they are in deep crisis. They need to stop this atleast when taxpayers will bail these banks out

2008 Sep 27 03:39 AM

[irondoor91:]

I heard somewhere that there were millions of people sitting around doing nothing but living off the government, food stamps, rent-free in air conditioned apartments, color TV, microwaves, free medical care, etc. They do not pay any taxes on their cash incomes. But they are not satisfied or grateful to their fellow citizens. They are parasites and will be until they kill the host. They always want more, more, more.

2008 Sep 27 11:16 AM

[late for di...:]

People usually tend to go where the jobs are. Since we outsourced almost everything real that needed top be deisgned and manufactured people had to go to the financial sector as the only place left. They designed and manufactured the CDO's etc. and sold them like any other product. I think outsourcing is also a big cause of the problems we have today.

joyrose

2008 Sep 28 12:48 PM

[helplessobs...:]

GS employees are overpaid getting 61% of gross revenues. They should give back the $27B in bonus funds recently found in their pay envelopes.

2008 Sep 28 05:03 PM