Money for Nothing
Quite a media hullabaloo was raised when the New York Times reported a week ago that Citigroup's head energy trader, Andrew Hall, was possibly collecting a $100 million bonus for the profits his group earned in 2008--most if probably not all of it made trading on the price of oil. Hall is one of those independent-minded, nervy traders who generate enormous profits when they are right. Remember, the price of oil rose to $145 a barrel last summer, before plunging to roughly $35 in the next six months. It's possible Hall made money in both directions--first by betting long (counting on a price rise) and then by betting short (predicting a fall). But even if he has lost money on balance in 2009, it is unlikely he would have to return any of that huge bonus. That's because Wall Street employees have a very sweet deal: it's heads I win, tails you lose.
What has everyone especially up in arms, however, is that Citigroup is still a ward of the state, as the Times put it. The US government has a 34 percent stake in the bank holding company, which received some $45 billion in bailout money. It is pretty understandable that people are furious it is being used to finance these outsize bonuses.
But what should really have the public upset is that it is increasingly obvious these star traders and bankers do not deserve the money in the first place, bailout or not.
Many of us may feel this in our guts. But now a couple of mainstream economists have gathered some serious evidence to support the case. They find that big profits on Wall Street, and the big bonuses they fund, don't reflect the value these firms add to the economy. They would add just as much to the economy through accessible and cheap financing and innovative investment vehicles at much lower levels of profits and individual compensation.
We have been waiting for mainstream economists to rise to this challenge for years. Now, several seem to be doing it. In one study, Thomas Philippon of NYU examined financial innovation and comparative worker compensation in the financial industry since the early 1900s; his paper was published by the National Bureau of Economic Research. Philippon put together a sophisticated benchmark to analyze the pay in finance compared to pay for those who work in other professions and have comparable abilities, experience and education, among more sophisticated variables. One of the technical points is that, if the chances of being laid off are high, compensation should also be higher due to the risk. He adjusts for that issue and some other esoteric factors.
What does Philippon find? That since the late 1990s compensation has risen far faster than in previous periods, including the flamboyant and highly speculative 1920s. For more than a decade, financial pay has been up to 50 percent higher than what it would have been if it were based on what the finance industry contributes to the economy.
The results of another study, by Lawrence Katz of Harvard, are more striking. He and the economic historian Claudia Goldin, also of Harvard, tracked the careers of Harvard College graduates from three periods: the early 1970s, early 1980s and early 1990s. Katz and Goldin compared these students across many criteria: SAT scores, grade-point averages, years at work, size of family and so on.
The conclusions are pretty stunning: Many more college grads went into finance in this period than in previous years, as one would expect. That is no surprise. But the premium they earned over their comparable colleagues was enormous. Katz and Goldin found that the grads in finance made on average 200 percent more. The study is published in the May 2008 special issue of American Economic Review, "Papers & Proceedings."
Where did the money come from? As the economists put it, it could only have been possible over so long a period of time if the financial employees shared in enormous "rents" earned by the industry. "Rent" is a technical term, meaning that these financial firms generated revenue well above what is justified in terms of what they contribute to the economy's efficiency, productivity and growth. To put it another way, financial firms would have undertaken the same activities for much less profit--and their employees would have done the same job for much less compensation.
Competition is supposed to wither such surpluses away. At least, that's the long-standing argument for a free market. But if this is true in other industries (and it is probably less true than is widely believed), it is clearly not so in finance. They made money not because they deserve it, but because of a special advantage they have.
All of which begs the question: Why does the financial industry make such high rents--that is, make more than can be justified by their contribution to economic growth? Is there too little competition? Is it easy to cheat investors or manipulate markets? According to modern economic theory, there may be a lack of adequate information about the finance industry's complex products, which would give these firms a distinct and persistent advantage. Or, alternatively, is there simply a constant flow of inside information?
One can only hope good economists will now turn more of their attention to the sources of this undue advantage. In the meantime, it is increasingly clear that these bonuses are not justified by the competitive marketplace. They are the fruits of unfair economic privilege. The money could be far better invested elsewhere.