My Two Cents

The GDP report: Cold comfort

Chris Farrell Jan 30, 2009

The headlines are saying the 3.8% decline in gross domestic product for the last quarter of last year isn’t as bad as feared. That’s cold comfort. It’s a bad report that will likely be revised downward. It confirms the economy is picking up downward momentum. It’s getting worse, too, if the stunning job cut figures of this week are any indication.

These are not good numbers:

Consumer spending fell 3.5%, following a 3.8% fall the previous quarter.

The core consumer price index (excluding food and energy) rose at a mere 0.6% annual rate in the fourth quarter. Headline consumer inflation plunged at 5.5% annual rate. That’s the biggest drop on record. It’s also really scary. The combination of a steep drop in demand and falling prices defined the Great Depression.

I don’t like this either: Business investment is down 20.1%, and investments in equipment and software fell almost 28%.

Exports are down sharply too. This is a global recession, gaining momentum.

And Wall Street thinks it’s business-as-usual. Workers are losing their jobs. Businesses are falling into bankruptcy. There are no profits on Wall Street–in fact, there are no investment banks left–taxpayers are bailing out the industry, and the industry forks out over $18 billion in bonuses?

In Wages and Human Capital in the U.S. Financial Industry, 1909-2006, a recent paper by economists Thomas Philippon and Ariell Reshef, looks at compensation in the industry over nearly a century . Here’s the abstract:

We use detailed information about wages, education and occupations to shed light on the evolution of the U.S. financial sector over the past century. We uncover a set of new, interrelated stylized facts: financial jobs were relatively skill intensive, complex, and highly paid until the 1930s and after the 1980s, but not in the interim period. We investigate the determinants of this evolution and find that financial deregulation and corporate activities linked to IPOs and credit risk increase the demand for skills in financial jobs. Computers and information technology play a more limited role. Our analysis also shows that wages in finance were excessively high around 1930 and from the mid 1990s until 2006. For the recent period we estimate that rents accounted for 30% to 50% of the wage differential between the financial sector and the rest of the private sector.

In other words, your suspicion that Wall Street is vastly overpaid is right. Their conclusion, which touches on regulation, is worth highlighting:

Finally, we address the issue of the level of compensation in the financial industry. On the one hand, the change in the relative wage of finance employees is part of an efficient market response to a change in the economic environment. We show in particular that corporate finance needs from the non financial sector help explain the demand for skills in the financial industry. On the other hand, we find that rents account for 30% to 50% of the wage differentials observed since the late 1990s. In that sense, financiers are overpaid.

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.45 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.

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