Quite a media hullabaloo was raised when the New York Times recently reported that Citigroup’s head energy trader, Andrew Hall, was possibly collecting a $100 million bonus for the profits his group earned last year–most, though 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. 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 government has a 34 percent stake in the bank holding company, which received some $45 billion in bailout money. People are understandably furious that the money is being used to finance these outsize bonuses. But what should really have the public upset is that these star traders and bankers do not deserve the money in the first place, bailout or not.
Many of us feel this in our guts. But now some mainstream economists have gathered 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 through accessible and cheap financing and innovative investment vehicles, at much lower levels of profit and individual compensation.
In one study, Thomas Philippon of NYU and Ariell Reshef of the University of Virginia examined financial innovation and comparative worker compensation in the financial industry since the early 1900s; their paper was published by the National Bureau of Economic Research. The authors put together a sophisticated benchmark to analyze the pay in finance compared with pay for those who work in other professions and have comparable abilities, experience and education, among more sophisticated variables. What did Philippon and Reshef 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 and Claudia Goldin, both of Harvard, are more striking. They tracked the careers of Harvard College grads from three periods: the early 1970s, the early ’80s and the early ’90s. Katz and Goldin compared the students across many criteria: SAT scores, grade-point averages, years at work, size of families and so on. The conclusions of the study, which was published in the May 2008 American Economic Review, are stunning. Many more college grads have entered finance since the early 1970s than in previous years. That’s no surprise. But the premium they earned over their peers in other fields was enormous. Katz and Goldin found that the grads in finance made, on average, almost 200 percent more.
Where did the money come from? As the authors of the two papers put it, this income disparity was possible over such a long period only because the financial employees shared in enormous rents earned by the industry. “Rent” is a technical term meaning financial firms generated revenue well above what is justified in terms of what they contributed to the economy’s efficiency, productivity and growth. To put it another way, the 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 away such surpluses. At least that’s the longstanding 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. The younger analysts made money not because they deserved it but because of a special advantage they had.
All of which raises the question: why does the financial industry make such high rents? 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 industry’s complex products, which would give these firms a distinct and persistent advantage. Alternatively, is there simply a constant flow of inside information?
One can only hope good economists will 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 marketplace. They are the fruits of unfair economic privilege. The money could be far better invested elsewhere.